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Transforming The Way Affordability Is Assessed
Author: Tommy Mermelshtayn, Head of New Markets & Strategy, Veda
Article Posted: May 02, 2016
http://www.australianbankingfinance.com/banking/transforming-the-way-affordability-is-assessed/
There is a pressing need in Australia to improve how loans are approved, and ‘affordability assessments’ sit at the centre of that transformation, argues Tommy Mermelshtayn, Head of New Markets & Strategy, Veda.
INCOME VERIFICATION OR, for that matter, any single ‘affordability indicator’ used to deter- mine the suitability of a credit contract, is by itself insufficient. In fact, indicators such as these are failing both customers and lenders. Alone, a single indicator cannot truly assess if a borrower can afford a credit contract. While affordability as a concept is a relatively new one for Australia, it has been in the vocabulary of UK and US lenders for years now.
Affordability is a customer’s capacity to service debt over an extended period of time, not just when they apply for a loan, and without facing hardship. Importantly, true affordability assessments also take into account a range of factors such as the stability of a borrower’s employment, their ability to shift discretionary and non-discretionary spending and potentially even interest rate movements.
Increasingly, Australian lenders will be pushed to adopt a more robust and holistic view of affordability, as credit providers face greater scrutiny by the Australian Securities and Investment Commission (ASIC). ASIC is charged with the responsibility to ensure that credit providers lend responsibly. While not prescriptive in nature, the principle-based approach ensures that any newly approved credit commitments are suited to a consumer’s particular circumstances and do not result in a consumer taking on debt they cannot afford.
To meet this goal a range of customer specific and more general macro-economic factors need to be accounted for in the approval process, depending on the nature of the credit contract. However, credit providers should not see this as purely a regulatory burden. If addressed correctly, lenders will also be able to improve their customer’s experience and their bottom line.
The transformation begins
Lenders are beginning to adopt new evaluation methods to meet responsible lending obligations and the regulator is clearly communicating its expectations through a range of enforcement actions. The 2014 Cash Store ruling in which ASIC successfully prosecuted a small amount lender for failing to make meaningful enquiries about their customers’ financial circumstances will likely become a watershed moment. It was the first federal court ruling to help lenders interpret the regulator’s expectations and led to an update of RG 209 Credit licensing: Responsible lending conduct.
One major shift has been the movement from the outdated practice of re- lying solely on an index to determine borrowers’ living expenses. For example, one major bank that solely relied on the Henderson Poverty Index (HPI) to estimate the living expenses of customers applying for home loans was singled out. Using this index did not adhere to responsible lending obligations as outlined by ASIC, so the bank acted quickly to improve its lending practices.
Asking the right question
Australian lenders have traditionally been asking ‘will customers pay, based on a number of static data points?’, but really they need to be asking ‘can the borrower afford this loan throughout the lifecycle of a loan?’ The nuance is small but unmistakably important. Assessing a customer’s ability to afford a loan over an extended period of time is a dynamic challenge and a multi-layered approach is needed. A range of data points, depending on the type and size of the credit commitment, need to be considered. Key inputs may include the borrower’s verified income and expenses, credit history, their type of employment, assets including savings, and macroeconomic factors such as interest rate movements.
The data points required for specific credit applications will be dependent on the type of commitment and the borrower themselves. Critically though, the data must be accessible and verifiable. Real-time data, along with predictive analysis, will become the hallmark of best practices.
Customer experience and the bottom line
There is a strong correlation between robust affordability assessments and effective management of bad debts. Upfront and comprehensive affordability assessments will be instrumental in not only adhering to responsible lending laws, but also shaping the customer experience and positively impacting the bottom line. Lenders with robust practices are better placed to withstand shifts in the credit cycle.
Multi-layered affordability assessment
Developing the infrastructure to have ac- cess to multi-layered affordability assessments will be a challenge for lenders in Australia, but 2016 will see great in-roads as local lenders begin to develop new methods, the regulatory expectations become clearer and lessons learned from the UK and the US are imported into Australia. Credit providers are beginning to harness the power of data at their disposal to truly assess affordability. For providers that already have a customer relationship, early wins can include the evaluation of customer behaviour and transactional data. Similarly, as comprehensive reporting takes hold, a more complete picture of an applicant’s true financial standing will become more apparent.
Lenders over time will continue to improve the way they leverage both internal and external data as part of an affordability assessment. Income and expense verification is a first step, but data relating to assets, employment status, models (income / expense / indebtedness) and macroeconomic factors will all have a role to play depending on the specific credit contract and customer circumstances. Cross-referencing a range of sources in a seamless fashion to ex- tract the greatest meaning while minimising the inconvenience to customers will become a key competitive advantage.
What’s the next step?
We can see lenders begin to develop a data-driven approach to the affordability challenge. One of the early wins for both the credit provider and customers is unlocking the power of transactional data at the point of application. Lenders with transactional banking relationships have been asking loan applicants for proof of income such as pay slips, yet they readily have the required data at their disposal to verify income. The same transactional data can also be part of the analysis of living expenses, while at the same time help deliver a far superior customer experience.
Lenders of all sizes will have to transform, but if fully embraced, future affordability assessments can be a win-win for lenders and their customers.