Citizens Financial Revs Up Auto-Loan Risk

Citizens Financial in Providence, R.I., is inviting more risk as it pursues growth and the loyalty of its new investors.

The company, whose shares began trading in the fall, has vowed to improve its lackluster earnings, and nothing says more about that pledge than its ambitious strategy to drive auto-loan growth.

The $133 billion-asset Citizens has expanded its dealer network and loosened its credit standards. The results are starting to show: it made $6.4 billion of auto loans last year, 45% more than in 2013.

Granted, many banks Citizens' size are feeling the heat to expand revenue now that they have exhausted other options like lowering loan-loss reserves and cutting costs. But the pressure is even more intense at Citizens, a chronic underperformer that is being spun off in stages by its parent company, Royal Bank of Scotland.

"We very publicly made some commitments to transform the profitability of Citizens over the years, and auto is one of the key pieces of that," said Brendan Coughlin, Citizens' head of auto and education finance. "It's about having a business that has a better return profile for the company long term."

Citizens' auto expansion is part of a companywide strategy to turn around years of sluggish earnings — a necessary move for the newly public company, analysts say. Citizens was wholly owned by RBS until last September, when 25% of the U.S. unit was sold in the first of several planned offerings. Citizens filed with regulators last week to sell another $100 million of stock. RBS is using the proceeds from the offerings to help repay a bailout from the British government.

Citizens' profitability has lagged behind that of other U.S. regional banks returns for years; its overall return on equity last year was 5.1%, below the 8.89% average ROE for banks with assets of $50 billion or more, according to Federal Deposit Insurance Corp. data.

Chief Executive Bruce Van Saun has promised to do better. He wants to reach a 10% return on average tangible common equity by the end of next year, up from 6.71% at the end of 2014.

He plans to get there by cutting costs and taking on more risk in consumer lending. Along with auto, Citizens is targeting private student loans, another market that has been abandoned by some lenders and seen troubling credit trends.

Last September Citizens began refinancing both federal and private student loans. It got about $1.5 billion worth of applications in the fourth quarter and has approved about 65%, Coughlin said. Citizens is targeting older, securely employed borrowers who have proven themselves creditworthy. The aim is "to allow students who have earned a better deal to get one," he said.

Citizens' auto-loan shakeup is having a greater impact on the bank's balance sheet. Citizens began reaching down the credit spectrum and offering longer-term auto loans last year, a major change for a company that previously "wasn't taking any risk" in its auto lending, Coughlin said.

Citizens is keeping away from subprime loans, Coughlin said, though it lends to customers with credit scores as low as 620 if they pass other risk screens. Citizens has begun offering loans as long as 84 months, but will not use longer loans to "get customers into a car they can afford," Coughlin said.

The timing of the move — coming as regulators are warning of an auto-lending bubble -- could raise some eyebrows, but Citizens is far from the only bank to decide that the rewards from lowering credit standards outweigh the risks. Bank of the West, another foreign-owned company whose profitability has lagged, said in January it would loosen underwriting standards for certain consumer loans.

Coughlin thinks Citizens' auto growth is responsible, and that concerns about prime-level auto lending are misplaced.

"I don't think the fear is real for the banks staying right down the fairway and seeing growth in a safe and affordable way," he said. "I would say problems are further down the spectrum."

Analysts who follow Citizens are reluctant to discuss the quality of its auto-loan pool without knowing its specific standards for underwriting and collateral. However, credit quality remains strong so far and, while provisions are likely to increase, the company's loss projections are "better than what we had estimated," a group of JPMorgan analysts wrote following Citizens' first-quarter earnings release in January.

If widespread credit problems arise in auto lending, they are likely to start in subprime, though it is anyone's guess how far up the credit spectrum they could go. Regulators have been warning banks about dangers in the subprime auto market for more than a year, and some banks have pulled back. Wells Fargo drew attention this month when it decided to cap subprime credits at 10% of total auto originations.

Fitch Ratings said last week that subprime auto credit has started to weaken, largely because smaller nonbank lenders have loosened loan terms to win market share. But Fitch analysts think the credit problems will not hurt banks, which are not heavily exposed to subprime. The loss rate for banks' auto loans in the fourth quarter was 1.06%, up 5 basis points from a year before, but still extremely low by historical standards, Fitch said.

The low loss rate could suggest that Citizens has a ways to go before it risks serious credit problems. Fitch analyst John Bella does not expect to see high losses for auto lenders that stick to prime loans, and he thinks the fourth-quarter uptick is just an unusually low loss rate returning to normal.

Loss rates "have been at or near historical lows for quite a while," Bella said. "There was no way the indexes were going to continue to represent that kind of behavior."

Citizens has been an outlier even in that strong credit market — but not by design. Until late 2013, the bank originated auto loans using a 20-year-old mainframe computer system, which made sophisticated risk management impossible.

Unable to price riskier loans, Citizens offered only what Coughlin called "superprime" loans -- those to borrowers with top-tier credit scores. The average score for an auto borrower was 775 before the new credit policy, Coughlin said.

That approach worked during the downturn, but stopped being viable when loan demand returned.

"As we emerged back into a very competitive landscape, it was clear that being superprime-only is not a winning strategy," Coughlin said.

Citizens installed a new origination system near the end of 2013 and began ramping up originations. The new software allows more sophisticated risk management — requiring different loan-to-value or debt-to-income ratios when a borrower has a lower credit score, for instance — and lets Citizens lend further down the credit spectrum. The company also began buying auto loans last May, and plans to buy about $2 billion a year.

The credit expansion has improved Citizens' relationships with its dealers, Coughlin said. Its network grew to 6,700 from 5,500 dealers at the end of 2013, even as it selectively pruned dealers that were not a good match.

When you offer only the safest loans, "you end up just being a niche," Coughlin said. "Now we're getting more of everything from dealers."