Beginning on March 30, 2020, the U.S. Department of Education suspended federal student loan repayments and halted collection on defaulted student loan debt.
After a three-year pause on student loans with an interest rate forbearance of 0%, payments resumed in October 2023.
43.6 million borrowers owe a combined $1.64 trillion in student debt, according to the office of Federal Student Aid.
With consumer spending already slowing because of inflation, some believe the resumption of student loan payments will tip the U.S. economy into a recession. The yearly drag on discretionary income from these loans comes in at $70 billion.
Others expect student loan resumption will harm consumer spending, a leading indicator of economic downturns, but not enough to cause a recession.
Analysts at Goldman Sachs, who have been bucking conventional wisdom on the inevitability of a recession since mid-2022, argue that student loan payments will decrease consumer spending by 0.5% points in Q4 2023, according to an article from “The New York Times.”
That alone would likely not bring about a recession, although the cumulative effect of higher interest rates, businesses cutting back on spending, and student loan repayments could produce this outcome.
Regardless of the macroeconomic impact, credit unions and community banks will likely have consumers unable to pay on outstanding loans because of resuming student loan payments.
The National Credit Union Administration (NCUA) released guidance in October concerning the increased risk credit unions may face with the resumption of student loans.
In this article, we will examine the NCUA guidance and explore risk management strategies for community banks and credit unions to tackle a possible deterioration in their loan portfolios.
NCUA guidance for managing credit risk as student loan payments resume
Managing this credit risk has two essential components: implementing strategies for identifying and assisting consumers unable to repay loans and assessing the impact on your institution’s bottom line.
Addressing the credit risk from borrowers with resuming student loan payments will go a long way in assessing the impact on your bottom line, thus satisfying examiners.
NCUA notes that credit unions may soon experience:
- A higher rate of delinquency on outstanding loans
- Lower credit scores for members
- Increased concentration of credit risk depending on how many members owe on student loans
- A decline in individual loan performance
- Larger losses in their loan portfolios
Dealing with borrower stress from student loan payments requires several credit risk mitigation strategies. Financial institutions should:
Conduct Risk Assessments
Understanding your key risk indicators (KRIs) for credit risk is always good practice. Your FI’s KRIs for credit risk include higher default rates, declining credit scores, and increases in riskier loans in your portfolio.
Concentration risk – the percentage of your consumers resuming student loan payments – will play a significant role in this instance. Financial institutions need insight into borrowers’ exposure to federal student loans, particularly those with an exposure greater than 100% debt-to-income.
The guidance recommends that financial institutions identify consumers with significant student loan balances relative to income. FIs can examine consumer student loan payments before March 2020 and any private student loans from their institutions to better grasp borrower exposure.
Reach Out to Borrowers for Loan Modifications
After identifying borrowers under stress from student loan payments, financial institutions should proactively reach out to them. Providing consumers with information about eligibility for loan modifications reduces the likelihood of default and offers much-needed relief.
NCUA’s guidance states: “The use of well-structured and sustainable loan modifications is often in the best interest of both the member and the credit union.” One stipulation: loan modifications must be made on a consistent basis to comply with fair lending laws and regulations.
Both credit unions and banks must ensure that borrowers receive the same treatment in loan modifications. The CFPB’s ECOA supervision and examination manual understands loan modifications as an “extension of credit subject to ECOA and Regulation B.”
Monitor Loan Portfolio Performance and Develop KPIs for Modifications
Financial institutions should monitor loan portfolios for consumer segments with higher student loan payment exposure. Doing so will allow them to determine and measure key performance indicators (KPIs), establishing benchmarks for managing the risk of financially distressed consumers.
FIs may encounter consumers with multiple layers of credit risk. In addition to student loan payments, community banks and credit unions should carefully monitor consumers with the following characteristics:
- Private student loans with a higher APR
- Credit card balances
- Adjustable-rate mortgages or home equity loans that have time-sensitive resets
- High debt-to-income ratios or low credit scores
Implementing KPIs regarding what your institution hopes to achieve for consumers facing payment difficulties serves a crucial role. Your KPIs may be related to operational efficiencies such as loan modification processes and answering consumer questions. They might also account for any lost revenue or expenses associated with changing the loan terms.
KPIs for loan modifications determined by loan portfolio performance may include:
- The volume of loans that require modification
- Approval and denial rate of modifications
- Consumer satisfaction with the loan modification process
- The default percentage on modified loans
- Completion time for loan modifications
Before you begin the process of modifying loans, it’s essential to establish metrics that determine what success looks like.
Related: Key Performance Indicators in Banking
Allowance for Credit Losses (ACL): regulatory considerations for financial institutions evaluating credit deterioration by risk characteristics
Under current law, financial institutions must maintain a reserve for bad loans and other advances. Allowance for Loan and Lease Losses (ALLL) represents the valuation account FIs prepare to avoid overestimating loans receivable.
ALLL uses an incurred loss methodology known as Current Expected Credit Losses (CECL), which functions as the gold standard in financial accounting for credit losses.
At the same time, ALLL does not prescribe a process for segmenting credit losses based on specific risk characteristics. To satisfy examiners and ensure that the risk of borrowers resuming student loan payments receives the appropriate attention, many financial institutions have embraced technology to create and automate controls suited to their unique risk environments.
The NCUA and other regulatory agencies encourage credit unions and community banks to work with borrowers impacted by student loan repayments in offering relief. At the same time, regulators recognize that FIs need effective controls and oversight, while also upholding all applicable consumer protection laws in making loan modifications.
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