Helping handoff: more profitable than vanilla lending, but more "high maintenance," specialty-...

When the housing market is flush, it generates a good bit of business for the banking industry. But in less expansive times, mortgages produce on the edge of a razor, so to speak.

It's a good thing, then, that banks change up their business models to compensate. Specialty lending,

"Banks get into these areas, because, as a rule, each is more profitable than plain vanilla lending," notes John T. Weisel, senior managing director, specialty finance, Accenture, New York City.

ABA's own statistics back this up. As highlighted in the 2005 Home Equity Lending Survey Report, banks with home equity lines of credit, as one example, earn 1.5% on those products on average, compared with a 1% return on assets overall.

While the need to cut down on cost and complication through outsourcing has long been true in other areas of banking, it is also increasingly the case with niche areas on the retail-lending front. These areas include post-origination back office work related to issuing auto loans or offering leasing services. In these areas, business costs can be higher because the technology is fragmented and the business process knowledge required is significant.

"These loans require particular processing expertise to manage them throughout their lifecycle," Weisel adds. "To cope, more banks are working with outsourced partners at every phase, post-origination, to enjoy the upside without all the burden of back-office management."

At the time of the ABA survey, the HELOC market was concentrated (the top five banks in HELOCs took 51% of the total outstandings and their holdings grew 100% from 2003 to 2004). Quality was also shifting. An apparent decline in underwriting standards was indicated, in part, by the rising share of the sub-prime and alt-A market.

An alternative to commercial real estate?

In 2006 concerns over cost have become heightened. Moreover, costs are "increasing geometrically among community bankers," notes R.W. Christensen, Jr., president and CEO Enhanced Technology Financial Services, Inc., Olympia, Wa. This is happening at a time when regulators are expressing concern about credit quality and about overconcentration in real estate. What's his thinking? With credit quality concerns, banks need to make each loan in the pipeline more profitable by trimming costs.

ET, as it's known in lending circles, is in a position to know. Founded in 2004, it originates, services, collects, and reports on private label consumer loans for community and mid-sized banks using its proprietary OSCAR system.

Put together by "a guy in finance who saw the need for an improved back-office process for lending," Christensen says ET functions under the dual premises that banks have an overreliance on commercial real estate and that they will have an eventual need to shore up their deposit base by building deeper relationships with consumers. Christensen, who for 26 years was head of Bank of America's "loan factory" in the Arizona market, notes that shifting market dynamics have brought more business to its door of late.

"The Fed and others are applying enormous pressure to banks to diversify their portfolio and it's during times like these when getting all the operations costs reduced and well managed becomes more critical," he explains.

Christensen adds that in the origination aspect of the lending cycle alone, ET can reduce the net costs to the consumer by 100 points even as it carves out costs of 200 basis points to a typical lender.

Other partners, other options

These days, even specialty lenders that have the expertise are turning to business process outsource partners so that they can devote their resources to adding business by functioning as a marketing and sales pipeline. In this role, lenders determine product features, pricing, and rates as well as conducting credit risk assessments, but otherwise stay out of operations, which are handed over to partners.

"Banks are always asking themselves what level of staffing is appropriate, and they do well whenever they can turn fixed labor costs into variable costs," says Lowell Middleton, president and CEO of Outsource Financial Services, Tempe, Ariz. OFS handles outsourcing for loan origination.

As with ET and OFS, outsource partners can take on any or all pieces of the processing value chain, including servicing, collateral management, escrow management (in cases of real estate), or delinquency management. While many nonbank finance and technology companies (such as EDS's Wendover Financial) play roles in the lending outsource market, banks are also in the act. These correspondent-style relationships focus on processing and serve as an alternative to doing it yourself, traditional nonbank outsourcing, or relying on application service providers.

The banks that offer these outsource services include Citicorp, KeyCorp, and others in the top 20. In commercial real estate, Midland Loan Services, Inc., (PNC), and Wachovia hold the biggest market shares along with GMAC, including its Capmark subsidiary.

In the non-mortgage consumer lending sector, money center banks all support the deals of mid-market banking customers on discrete terms--meaning, they might handle servicing, or might handle some narrow slice of the post-origination work, or bundle together a spate of services designed to add clarity and cut cost from the process.

End-to-end processing

Then there is Pittsburgh-based PNC Consumer Services, which is building a book of business with a comprehensive service set that engages lifecycle management, including processing work for home equity lines of credit, personal loans, and "everything that isn't a mortgage or a credit card," according to President Jim DeFoggia.

Running down the full cadre of services PNC offers, DeFoggia explains that PNC Consumer Services, which became a unit of PNC Bank eight years ago, is aimed at processing for three markets: retail banks, from $1 billion in assets to the size of PNC Bank (whose work it handles); investment banks, which buy loan assets to securitize and need back-office work done; and diversified financial services companies like Discover, eTrade, and American Express.

John Billings, senior-vice president and director of financial institutions at KeyBank, says his bank has more traditional correspondent banking relationships with smaller institutions, but in the equipment leasing area, it has a division operating out of Denver and is the third largest full service provider among bank-owned leasing outfits.

"We tend to look at our [banking] clients in terms of their strategy and say, how can we help this bank round out its operations and keep costs down," Billings says. Although broad-based lending BPO is not what his bank does, Billings observes that, "banks, particularly smaller institutions, are trying to build their balance sheets and generate fee income. Any non-earning assets have to be leveraged appropriately. So you'll see core processing, leasing--derivatives--anything that would bring a revenue stream but is also capital intensive get outsourced. It makes sense."

While banks need to carve out cost, they also need to engage in more aggressive risk management, notes Tim Davis, managing partner, BearingPoint, McLean, Va. "In rising interest rate environments, delinquencies become more of an issue."

FitchRatings Resource website noted that special service providers are becoming more prevalent in handling delinquencies in the residential real estate market in recent years. "Banks that work with others tend to think of it as a way to offer their customers a wider array of services while mitigating their risk," adds Accenture's Weisel.

"We believe that banks--both those offering lending services and those engaging in contracts are, these days, thinking of the value chain more inventively and want to reduce back office cost and complexity," he says.

Such complex delivery arrangements are increasingly a fact of life. Accenture itself is building its business process outsourcing practice and is helping banks that outsource by supplying key specialty services on the technology and business process re-engineering front, including workflow and imaging. This "coopetition" will increasingly play a role in the business.