Current methodologies and approaches used by banks etc. for credit scoring for mortgages, credit cards, overdrafts and personal loans are outdated. They are static and only take into consideration the applicants circumstances at the time of applying for the loan. In reality, the applicants’ personal circumstances are likely to change over time but this in not reflected in how lenders manage that relationship.
In reality, therefore, whilst the data used might have become more sophisticated, the credit scoring approaches used today are those that were initially developed in the 1970s and 1980s when for the first time, significant numbers of people were seeking and had access to credit initially through mortgages but then through Hire Purchase Agreements, Personal Loans and Credit Cards.
The models were developed against a very different social and economic backdrop than that which exists today – meaning that they were ‘fit for purpose’ in terms of assessing an individual’s credit worthiness over the longer term:
Full or near full employment;
A ‘jobs for life’ culture;
High single digit or low double digit inflation;
Wage inflation and house price inflation outstripping the base rate of inflation meaning increasingly better living standards;
House purchase at an earlier age meaning borrowers had longer to repay;
More conservative lending regimes meaning less likelihood of customers becoming overstretched.
Whilst the economy and social attitudes to credit have changed dramatically, the principals of how money is lent have remained the same.
Against an environment of low inflation, reduced job security, higher unemployment and the extent to which credit is available at a ‘point in time’ there is an opportunity for more dynamic underwriting and better customer management to be introduced to limit both lenders’ and customers’ exposure to risk by accommodating these structural changes in peoples’ personal circumstances.
The problem will become more acute over time as job security becomes an even greater issue and as changes in the pensions environment compromise people’s ‘wealth’ in retirement.
An opportunity exists for lenders to further develop dynamic credit scoring and underwriting models, linked to segment based customer contact strategies to:
Manage better the relationships they have with customers to improve the quality of their credit books;
Manage their exposure to risk and improve their own credit ratings;
Price more effectively and efficiently for risk to compensate for exposure;
Position themselves better as responsible lenders and as having customers’ interests as a primary concern.
The opportunities exist for dynamic underwriting to deliver improved back book management particularly for mortgage books, credit card portfolios and current account overdrafts. Critically, the opportunity is for lenders to develop dynamic customer contact models and to use the credit data that is available to better manage the relationships they have with their customers – benefiting themselves from a credit and reputational risk point of view and benefiting their customers by being more transparent with them and helping them better manage their credit exposures.
By ‘dynamic underwriting’ we mean an ongoing system of understanding how changes in individuals personal circumstances are impacting or likely to impact their ability to honour existing credit arrangements and for lenders to put in place underwriting and customer management practices that accommodate these changes.
There are a number of legacy issues that are driving current practices and embedded operating practices that would need to change
Currently, if an individual applies for credit, this leaves a ‘footprint’ on their credit file. Repeated or regular applications for credit are indicators used by the credit referencing agencies to determine a person’s credit score. In order to introduce ‘dynamic underwriting’ it would be necessary for the credit referencing agencies to distinguish between credit checks for new lending and those carried out by lenders to determine ongoing credit worthiness.
The data lenders hold is often static and limited – this has exacerbated the practice of underwriting only at point of sale. The credit referencing agencies (Equifax and Experian) now have access to accurate, pertinent and relevant data that would enable lenders to underwrite dynamically. This not only includes credit data and changes in credit history, but changes to credit turnover (used to determine loss of employment/income) and changes in personal circumstances. Using banks’ own data, together with this external data provides the basis by which dynamic underwriting can be put in place. The external data can be purchased from the credit referencing agencies.
Because of the restrictions around funding and capital reserves banks, more than ever, need to manage the relationship between income and capital usage – so potentially pricing for risk to limit capital exposure and, where the risk is greatest to be able to either price out customers or at least charge a higher interest rate.
Typically also, because the majority of mortgage business in intermediated, the data which lenders hold on their mortgage customers is often extremely sparse.
Pricing opportunities exist where events such as fixed rate mortgage maturities mean that the customer is coming to an end of an Agreement. Higher risk customers could be offered a higher rate of interest than those with (current) good credit scores. This approach reflects the practices for underwriting new personal loans where higher risk customers pay a higher rate of interest. Rolling higher risk customers onto SVR will mean they either leave to seek a mortgage elsewhere or the lender is compensated for the higher risk lending by receiving a higher return.
Depending on the structure of the mortgage agreement, it might even be possible not to offer a continuation of the mortgage to customers whose credit rating has diminished significantly in the period from first taking out the loan to the maturity of their fixed rate.
Even in cases where there is no ‘event’ where the relationship can be reviewed, by applying dynamic underwriting processes to existing back books, mortgage lenders would have the capability to manage customers dependent on their exposure, credit rating, time to maturity, payment history etc. In this way, lenders will be seen as acting more responsibly and being more customer orientated – thus helping with credit ratings and reputational factors.
In the UK a specific issue exists around interest only mortgages and the financial and reputational risk lenders face from interest only mortgage customers being unable to repay their mortgages at maturity – dynamic underwriting will enhance significantly lenders’ ability to manage the risks associated with interest only mortgages by enabling better segmentation and more prescribed customer management approaches.
In the same way as for mortgages, credit limits on credit cards are established predominantly at the time the card is taken out and adjusted mainly only if there are payment issues. Whilst an individual’s circumstances may have changed dramatically therefore, their access to credit may not have.
Approaches could be adopted that take account of changed circumstances that also accommodate the outstanding credit balances, payment histories etc.
Interventions by way of issuing new cards provide an opportunity to change credit limits etc, impose or suggest different payment methods or schedules etc.
In the same way as for mortgages, the individual is being protected as are the financial and reputational risks of the lenders.
A similar situation exists for current account overdraft limits – opportunities exist for more proactive management by the banks by introducing dynamic underwriting approaches.
Whilst credit providers are getting increasingly better at managing risk and developing underwriting approaches that embrace new technologies and the availability of information, the ‘proof of the pudding’ will be how well they apply the learning through customer contact strategies that balance the needs of the lenders and those of the customers – balancing information with action and using credit history and behaviour to develop contact strategies that deliver the best commercial and customer outcomes with the greatest degree of protection for the lenders against commercial, regulatory and reputational risk.