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  • Frank Tian

Inflation Management and Risk Management

Updated: Dec 19, 2022

US inflation reached a new 40-year high at 8.6% in May.

How could the policymaker manage inflation differently?

Why not look at the risk appetite framework of consumer credit? 👇

There are similarities between the macroeconomy and a consumer credit portfolio.

  • Inflation can be viewed as a risk metric.

  • Too low - not enough economic activity (revenue).

  • Too high - some consumers suffer financially (loss).

Thus the target inflation is similar to the risk appetite of a consumer credit portfolio.

👉 Risk Appetite needs a clear Cap level and Alert level.

🚥 Cap Level

For a consumer credit portfolio, the risks appetite statement should have a clear risk metric with a Cap value, indicating the risk area that the portfolio should be operating within.

🚥 Alert Level

Under the cap value, there is another lower threshold set as the Alert level.

In the example shown in the exhibit, a credit portfolio has a portfolio risk appetite of an 8.0% net charge-off rate. The alert level is set at 6.0%.

Once the portfolio’s net charge-off rate is above 6.0% and still below 8.0%, it is considered to have entered the yellow zone.

Analysis and discussion are needed to understand the reasons behind the loss rate increase and any possible actions to manage the portfolio risk within the established 8.0% risk appetite.

In 2021, the Fed started to target the long-run “average inflation rate” at 2%. However, it did not specify any Cap level and Alert level, thus running the risk of acting late.

As all strategies’ impacts on a portfolio tend to be long-term, it is important to take mitigation actions while there is still a buffer, before the risk metric breaches the cap value.

If you only act when the risk metric is over the cap, it is probably too late.

Unfortunately, that is what happened to inflation.

The Risk Appetite part is an adapted excerpt from my book “Unsecured Lending Risk Management”.

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