01 March 2006 Features

 

Credit where it’s due

Increasing consumer debt and regulatory pressure mean that retail banks must get more information from their credit systems, reports David Bannister .

There used to be an old gag about how if you owed a bank £1,000, you had a problem, but if you owed them £1 million, the bank had a problem.

With growing levels of consumer debt, it looks like all those individual debts are building up to a level that moves the problem into the banks’ laps, and it is not just a question of market risk: reputations are taking a battering, too.

In the past year, there have been several high-profile stories in the media, including BBC Television programmes, focussing on inappropriate lending by retail banks — to customers receiving state benefits or with existing overly-high debt levels.

One reaction to these stories is that banks that make loans like that deserve all they get, and they probably won’t be around for long as competition sweeps them aside. The other side of that coin is that the banks doing the sweeping will have to use their existing technologies ever more efficiently, and the regulators are starting to take notice.

In its annual Financial Risk Outlook 2006 report, the UK Financial Service Authority highlights concerns that a slowing down of the retail banking credit cycle could be a potential financial risk. In particular, it says that: ‘At present this deterioration has mainly been confined to unsecured lending, in particular credit cards … if economic conditions worsened, banks’ model-based risk-management systems would be tested.’

According to statistics from the Bank of England and Apacs, the UK payments association, the ratio of personal debt to personal disposable income increased to 159% by the middle of 2005. Credit card arrears are rising — an increase from 7.4% to 8.5% in September 2005 and are like to continue to do so. The average adult in the UK has 3.6 cards (1.6 debit and 2.3 credit cards), according to Apacs.

The FSA report goes on to say that further industry developments will enable ‘better-informed lending decisions’ and even goes as far as saying that systems will be able to provide more information to ‘identify over-indebted individuals for debt counselling.’

There are a couple of aspects of these developments that are likely to be the focus of effort in the next few years. One is improving the use of systems and services, such as those supplied by companies like Fair Isaac and Experian, which have traditionally focused on the creditworthiness of customers and fraud, but are now increasingly being deployed to manage customer profitability.

An example of the former is the Strategy Optimization software from Experian-Scorex, part of the Experian group, that is being used by a number of institutions (see box, right). Strategy Optimization consists of data, model development, strategy consulting and software and enables organisations to identify which customers are eligible for which actions, predict how customers will respond to any treatment or offer, and then identify which offers or treatments maximise profits within the business constraints.

These constraints are often business targets, resource levels or financial. For example, in determining the best credit limit to offer to each customer, a lender can consider the overall level of lending that the business can accommodate or the level of bad debt that is acceptable. Using the simulation capability of Strategy Optimization, it can choose the strategy which reflects these additional factors, effectively enabling an organisation to interactively ask ‘what-if’ questions, such as ‘What happens if I increase my lending budget or lower the acceptable level of bad debt?’

“Through being able to ask and answer these questions, managers are able to make improved judgments about how best to invest, to overcome some constraints, where to concentrate scarce resources and, therefore, can really begin to understand the trade-offs between different business scenarios. In addition, changes in business conditions, objectives or constraints can be quickly reflected in the operational deployment of optimisation,” says Experian.

The system is capable of recommending the best action or decision for individual customers, providing superior financial results than ‘segment’-based approaches where the same actions or decisions are applied to groups of customers, which naturally means that some customers within the group are allocated sub-optimal actions.

The technology is the result of several years of research by an optimisation specialists team based in North Virginia. The company says that clients have already seen significant improvements in customer profitability between 20% to 40% is typical with some examples of up to 100% being seen. Clients include Capital One, Wells Fargo, The Royal Bank of Scotland and Abbey.