Coping in a cold climate

As arrears levels rise, Brian Rogerson looks at the strategies
and products that lenders are adopting in order to maintain – and
even increase – profitability
 
 
 

In 2008 UK motor lenders are facing a completely different
marketplace to even 12 months ago. Their colleagues in the
mortgage, credit card and direct loan sectors are now applying more
stringent underwriting criteria, and declining more proposals. They
are also tightening up their credit checks generally.

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Tighter credit lines, high LIBOR compared to base rate, creeping
defaults and record-breaking over-indebtedness amongst some
customers have served to concentrate the minds of risk managers.
And UK risk managers themselves stand accused of neglecting
counter-cyclical control mechanisms when times were good.

Looking more closely at applicants

“Lenders are looking deeper into people’s credit histories,”
confirms Neil
Munroe, external affairs director at credit reference agency
Equifax.
“In particular, we believe they will be looking in more detail for
early warning signs of consumers getting into financial
difficulties.”

He adds: “Lenders are also looking more closely at how consumers
service their debts – making only minimum repayments could count
against them on a new loan application. We now advise people, who
think that they may need new credit in the next few months, to make
sure that they stay up to date on all their existing loans and pay
off more than the minimum on credit cards each month.”

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With lenders increasingly looking more closely at borrowers’
credit histories, Equifax is developing specific scoring tools to
predict indebtedness, and potential bankruptcy, based on an
individual’s past management of their credit.

“This means,” Munroe says, “that any small blips in someone’s
credit rating – such as a missed payment on a mobile-phone account
– will be taken more seriously.”

.and more frequently

Peter
Brooker, director at credit bureau Experian
says: “Real-time notification services will become the bedrock of
risk management. Timely intervention prevents loss before it
occurs. Not only does this preserve profitability but it is
absolutely fundamental to responsible lending and good customer
management. In the current climate lenders need to manage their
customers more responsibly and ensure they have timely and accurate
intelligence to make customer decisions.”

Graham
Lund, deputy managing director at credit agency Callcredit
emphasises that, as the credit squeeze continues, lenders are
finding that updates to consumers’ profiles – on a daily basis –
allow them to detect early warning signs in 20 per cent more cases
than if they had used a monthly update service.

Underwriting – a more revolutionary
approach?

Some industry observers believe that, in addition to more
sophisticate monitoring of data, UK motor lenders need a more
revolutionary approach to underwriting in today’s climate.

Lawrence Whittle, vice president International at Nomis
Solutions tells Motor Finance: “We believe that unless
motor lenders very quickly modify their underwriting standards they
will face significant loss in the future.”

Whittle acknowledges the corollary of reducing volumes to tidy
up loan books. “The dilemma is of a reducing book, which is always
bad for credibility as well as morale. However, if lenders put in
place a better understanding of demand elasticity and how a change
in price could impact on criteria such as profitability, volume,
conversion rates, retention and default, the loss of turnover would
be balanced.

“After all,” he notes, “every other lending sector in the UK has
raised their interest rates as well as their cut-off points.” Many
also are implementing pricing for risk and even moving on to its
21st century cousin, profit-based pricing.

Whittle says that a profit-based pricing approach is geared
towards maximising profit without sacrificing market share: “Rather
than simply pricing for the inherent risk in selling the product,
motor lenders need to price for the brand value in which their
company is heavily investing. Past industry experience has
illustrated that the early adopters of profit-based pricing tend to
reap the greatest rewards.”

He adds: “In the US risk-based pricing is commonplace and most
motor lenders of some size are adopting profit-based pricing. I
believe that 2008 will be the year that UK motor lenders realise
that a change must be made – and 2009 the year when they implement
it.”

Avoiding the paradox of falling volumes

One paradox in times of tightening credit is the nightmare of
reducing volumes and the consequent strain on lenders’ fixed costs.
Risk-based pricing, however, in addition to defending against
default can create higher revenues through the higher prices
set.

John Putt, senior business consultant Global Consulting at
Experian-Scorex,
is certain about the long-term benefits of risk-based pricing. He
says: “For consumers the benefits are clear and becoming more
accepted. Lower-risk consumers are rewarded for their good
financial performance and can benefit from increased choice and
competitive rates.

“For higher-risk customers the gap between mainstream and
alternative finance sources can be significant. Those who
previously would only have access to sub-prime lenders now have
more access to credit and choice of lenders. Lenders that
previously would not have lent to these high-risk customers are now
lending at an appropriate price – so risk-based pricing brings more
of the population into the mainstream lending process.”

Putt stresses that for lenders the ability to price according to
risk can increase volumes through more lending to “good” customers
attracted by lower rates and increased lending to higher-risk
customers that previously would have been declined.

He says: “The better offers increase take-up and booking
volumes, helping a lender to reduce attrition and strengthen
relationships with low-risk, high-value existing customers.”

Fast ID checks integral to risk-based
pricing

Black
Horse Motor Finance’s risk-based pricing system, AutoRate Plus,
was launched last November with the object of underwriting on
individual customer profiles instead of solely on the age of
vehicles.

Integral to AutoRate Plus are accurate and speedy identification
checks. The company behind the ID verification is GB Group which
utilises URU, a joint development with British
Telecom, and which verifies the identity of UK citizens. It
also comprises ID3 Check which verifies the identity of over 800m
individuals across some 20 countries.

Karyn Bright, head of marketing at GB Group tells Motor
Finance that it is crucial for motor lenders to be able to
identify applicants who are the least risk as customers: “The
demographics of applicants with poor risk are changing and the
industry needs to adapt to that. At the same time lenders need to
adapt and flex their operating models in line with changing
demographics.”

She adds: “URU matches the information lenders give us against
more data sets than any other solution on the market. Since URU is
able to verify the authenticity of UK and international passports
and driving licences, it can find those customers who may not
otherwise have a footprint in society. With URU, match rates as
high as 92 per cent can be achieved – that means lenders need only
refer some eight out of every 100 new customers for additional ID
checks.”

Survival strategy for SMEs

While tightening underwriting and collection procedures are the
main aim of motor lenders at present, one company believes they
should look at the bigger picture for managing risk.

Incident Director Ltd was formed in 2007 with the aim of
advising small and medium-sized enterprises (SMEs) on
business-continuity management. Founding director Tony Worthy
explains that there is a clear role for cost-effective business
continuity: “There is a huge misconception that business continuity
is only necessary to protect an organisation against the big
disasters. But it is actually just as crucial – if not more so –
for making sure an organisation is prepared in case of a number of
other events. What would you do if your best people suddenly
resign? Or if one of your key suppliers goes under? Or a new
competitor opens up locally? Do you have contingency plans in place
for all these eventualities?”

Worthy says that some 80 per cent of businesses without a
business continuity plan fold in the aftermath of a major disaster.
“One in five businesses suffer a major disruption every five years
– and, if secured and paid out, business-continuity insurance only
recovers part of the actual cost of losses from
business-interrupting events that had not been previously
identified. That is why it is crucial for businesses to have a
clear business continuity plan.”

Risk-based model increases profits for
lender

John Putt, senior business consultant Global Consulting,
Experian Scorex gives an example of a lender that initially
achieved a £445,000 profit from underwriting some £32.5m of
advances. Originally the lender applied a fixed rate to all
applicants using a cut-off score to reject applicants considered
too high a risk.

Putt said: “To create a risk-based approach Experian-Scorex
worked with the lender to create a model template and pricing model
with risk bands based on the bad rate. Three tiers were created –
high, medium and low – with bad rates of 9 per cent, 4 per cent and
2 per cent respectively, with these bad rates used to calculate the
loss provision.”

Costs were estimated for each of the risk bands. The analysis
demonstrated that low-risk customers were contributing
significantly more profit than other customers, and that within the
high-risk group the lender was actually making a loss on some
accounts.

The lender adopted a scenario of increasing interest rates for
higher-risk customers, in order that they contribute to the
profitability of the portfolio, while maintaining the current
margins on low- and medium-risk customers. “This,” Putt added, “was
estimated to give an increase in profitability of some 44 per
cent.”

Going forward, the risk team plans to introduce a challenger
strategy which will test the effect of reducing interest rates for
the lower-risk customers to see if this increases the overall
response and therefore booking volumes. This might also contribute
to higher portfolio profitability.

Callcredit wins HBOS data-check deal

Mel
Mitchley, director of Industry Relations at Callcredit
believes that given today’s uncertain credit marketplace it is more
crucial than ever for lenders to access information frequently,
even as often as daily, in order to evaluate and pre-empt bad
debt.

She says: “We introduced CallMonitor in 2006 and it was the
first service in the UK to provide daily customer profile triggers
using SHARE, CCJ and bankruptcy data. It helps lenders to identify
key changes in their customers’ financial circumstances and enables
users to spot when consumers may be at risk over over-indebtedness
and identify any early signs of fraudulent activity.”

CallMonitor has been implemented at HBOS. Richard Fisher, head
of Banking Acquisition and Customer Management at the bank explains
that he was impressed with the system’s flexibility and ease of
use, particularly, he says, “with its ability to provide triggered
daily alerts which keep us informed of all customer activity and
enable us to take action on debt and potential fraud as an early
stage to limit loss and ensure responsible lending.”