Region V Reports
UNDERSTANDING CREDIT UNION INDIRECT LENDING PROGRAMS
Indirect loans are a critical part of many credit unions’
balance sheets. They have maintained a percentage of total
loans between 12.3 percent and 14.14 percent over the last
eight years. Many credit unions have increased their indirect
loan portfolio to offset declining loan demand elsewhere. As
of Dec. 31, 2011, there are 1,904 credit unions that have
indirect lending programs.
The benefits of an indirect lending program include potential
loan and membership growth, cross-selling opportunities, and
to centralized operations. Some of the potential drawbacks
from indirect lending include dealership fraud or
misrepresentation, increased loan losses, uncontrolled growth,
and lost income from add-ons sold by dealerships (e.g., loan
protection insurance). In addition, unpleasant membership
experiences could harm a credit union’s reputation. And lastly,
the dynamic nature of an indirect program dictates annual
analysis of the relationship, or more often as warranted.
Before starting up an indirect lending program, credit union
officials must consider several factors that flow from
developing the appropriate risk assessments and due
diligence procedures. One crucial factor is to plan before
implementation. Third-party arrangements should
synchronize with the credit union’s philosophy expressed in
their strategic and business plans.
Additionally, a credit union needs to establish clear polices
that include underwriting standards, documentation,
membership qualifications, program limits, dealer approval
and review, compensation agreements, and reporting
requirements. It is also important for credit union officials to
thoroughly understand the third party’s business model.
Balance sheet considerations are paramount due to the rapid
growth that may accompany these programs.
The following elements should be part of an indirect lending
program:
; Risk Assessment—Document assessments should
consider the effect on all seven risk areas (credit, interest
rate, liquidity, transaction, compliance, strategic, and
reputation). Other components to risk assessments include
expectations of the arrangement, staff expertise, criticality
of function, costs and benefits, insurance requirements,
member impact, and exit strategy.
; Financial Projections—Credit unions need to consider
expected revenues and expenses to project the return on
investment. Once the program is started, a credit union
should review actual revenues on a monthly basis and
compare the results to the budgeted projections to ensure
the program is a profitable endeavor.
; Cash Flows—Credit unions need to achieve clear
understanding of how cash is exchanged between the
member, third party, and the credit union.
; Financial and Operational Control Review—Credit
unions must carefully review the financial statements of third
parties and their closely related affiliates. Can these potential
partners fulfill the proposed contractual commitments?
Credit unions should give consideration to outstanding
commitments, capital strength, liquidity, and operating
results, as well as any potential off-balance sheet liabilities.
; Contract Issues and Legal Review—Credit unions need
to seek qualified legal counsel to review prospective third-party arrangements and contracts. Credit unions need to
exercise their right to negotiate contract terms that are
mutually beneficial. The dealership agreement will detail
each party’s responsibilities. It should provide recourse
while specifying the conditions that allow each party to
terminate the relationship. The agreement should allow the
credit union to audit or review the dealer’s compliance
with the contract. A consumer can hold a credit union
responsible if a dealership takes an action that violates
consumer protection laws (e.g., the Equal Credit
Opportunity Act or the Truth in Lending Act).
; Accounting Considerations—The adoption of an
indirect lending program may lead to greater complexity in
the accounting function that may necessitate engaging a CPA
who specializes in these types of third-party relationships.
Detailed below are three more issues that credit unions need
to address after implementing an indirect lending program.
Proper Controls
In order for an indirect lending program to provide benefits
for members, credit unions need to ensure these loans are
properly underwritten to the same standards as any other
loan product. New member applications through third parties
must be validated when received by the credit union. Once
membership status is validated, then the loan can be reviewed
for approval. Credit unions have been required to divest loans
because of a failure to implement proper membership
verification procedures.
The transfer of the lending transaction from the dealership to
the credit union is a key step to ensure indirect loans are
permissible. Assignment occurs when the dealership contracts
with the credit union to fund the loan. Prior to the assignment,
the dealer may be shopping the loan application to other
lenders. As discussed in the attachment to Letter to Credit
Unions 04-CU-13, indirect loans should be assigned to the
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