Achieving responsible lending by assessing affordability: The case in the UK
There is more pressure than ever on the Credit Industry to practice responsible lending in all its dealings with consumers. In the rapidly changing financial climate the number of people experiencing severe financial difficulties is rising with most markets seeing insolvencies and repossessions increasing.
This is particularly true in the UK and with it comes more pressure from the industry’s governing bodies and consumer support groups to lend ‘responsibly’ making sure that the individual can afford the debt taken.
This article discusses the responsible lending approach that has been adopted in the UK. The lessons learned from the UK have implications for many other developed - and developing - consumer credit markets.
A focus on responsible lending
It is now widely accepted that one of the main contributing factors of indebtedness has been the number of consumers that have 'over borrowed' - particularly on unsecured credit.
As a consequence of this, the UK credit industry is now looking to place even more emphasis on ‘affordability’ when lending to consumers. And this means that there is a pressing need for a means of delivering this capability into the highly automated systems that are now making the vast majority of consumer lending decisions.
Over the last 2-3 years there has been a greatly increased focus on ‘responsible lending’ from the consumer credit industry’s regulatory bodies and the 2006 Consumer Credit Act (CCA) creating an increasing internal and external pressure on UK lenders to not only lend responsibly but also to be seen to be doing so.
Responsible lending and the role of credit scoring
Credit scoring has been used successfully for many years for assessing the creditworthiness of new applicants for credit. But credit scoring has tended to focus on establishing an individual’s ‘propensity to pay’ rather than their ‘ability to pay’, and while credit scoring does deliver many of the elements required for responsible lending, it also has some limitations.
More recently, scoring models have also been used to identify consumers that are keeping up with their credit commitments, but that are actually highly indebted (Experian pioneered the use of this approach in developing its 'Consumer Indebtedness Index' in the UK ). But, because credit scoring has no specific income dimension, consumers with negative affordability can still be given additional credit based on their credit score alone.
All of which means that lenders need to incorporate a reliable affordability check into their decision-making processes to complement their credit scores and policy rules. And, while leaving the affordability assessment to an underwriter to make subjectively is one option, it is rarely going to be the best solution.
Assessing disposable income and affordability
Experian has been working on an algorithm for estimating Effective Disposable Income (EDI) for some time.
The traditional approach to calculating a monthly EDI has been to combine the following components:
- Net Monthly Income (NMI) [supplied via application form]
- Monthly Mortgage/Rent [from Credit Bureau or application form or modelled]
- Monthly Credit Commitments [from Credit Bureau]
- Monthly Expenditure [modelled]
For highly credit active households in particular, there is inevitably a high degree of overlap between monthly expenditure and monthly credit commitments. This, in turn, can lead to significant underestimates of EDI for these credit active cases - which are just the cases that require a reliable EDI to enable their affordability to be assessed accurately.
Following a good deal of research into this problem, Experian has developed an heuristic approach that allows for this effect by amalgamating monthly mortgage or rent, monthly credit commitments (MCC) and monthly expenditure (MEX) into ‘Monthly Outgoings’, along the following lines:
While the EDI provides a useful new tool for new business decision-making - particularly in the secured lending sector - it does not appear to provide a general predictor of ‘credit risk’.
This is probably not that surprising since income information rarely, if ever, makes a significant contribution to a credit scorecard. However, a useful new risk predictor has been produced by adding key application form information and other financial metrics to the Consumer Indebtedness model. On the indebtedness model development sample, the resulting ‘affordability’ score had a Gini Coefficient of 72 - a 12% increase over the Indebtedness score.
The problem of UK consumer indebtedness has been widely publicised, but it is certainly not solely a UK problem. EDI/AI approach is being applied in other markets where there is an increasing consumer indebtedness problem.
Simon Harben
SVP - Global Analytics
Decision Analytics
Experian
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