Credit Scoring - Topic P - Affordability

Credit Scoring Topic P Affordability

1. Credit Scoring Topic P Affordability University of Edinburgh

2. University of Edinburgh Credit Scoring Background Regulation Over-indebtedness Assessing Affordability Affordability

3. University of Edinburgh Credit Scoring Scorecard characteristics assess capacity, propensity and stability. In many cases, however, the scorecard does not deal with the capacity aspect well enough. This can be from a variety of points of view:   credit risk - losses regulatory risk - approved processes reputational or conduct risk – assessing customers fairly Affordability

4. University of Edinburgh Credit Scoring Scorecards may provide only one dimension to the credit decision. They need to be set within a wider credit policy which will incorporate factors such as:   Legal – 18+ Credit – Court decrees, LTV, Fraud indicators, insufficient income, no trace, missing information / incomplete application, max/min age Administrative – duplicate application   If a credit policy rule is triggered, this may generate a decline or a referral Affordability

5. University of Edinburgh Credit Scoring So we have the scorecard and policy steps, but still also need to assess if the applicant can afford the repayments on the credit facility. One might expect to see affordability characteristics in a scorecard, but they are not normally predictive of future risk. Despite this, there is growing realisation of the need to consider affordability when making credit decisions. Affordability

6. University of Edinburgh Credit Scoring In the Credit Scoring Toolkit (2007), Anderson noted that lenders try to use “ Acceptable practices that ensure borrowers can afford the repayments and know the consequences, and still try to accommodate as many people as possible ”. Regulators have also stressed the need for affordability assessments and responsible lending. It is now recognised that Irresponsible (reckless) lending has become a worldwide problem. Affordability

7. University of Edinburgh Credit Scoring USA - Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) South Africa – National Credit Act (2005) UK - FCA Policy Statement 18/19: Assessing creditworthiness in consumer credit - Creditworthiness comprises credit risk to the lender and affordability for the borrower. Most lenders have a strong commercial incentive to assess credit risk, including the probability of default, but may have less incentive to assess the risk that the credit will impact negatively on the customer’s wider financial situation, in particular, where these customers will still be profitable for the firm. We want to protect consumers from the harm that can arise when they are granted credit that is predictably unaffordable at the point it is taken out. At the same time, we want consumers to be able to access credit where it is affordable. Regulation

8. University of Edinburgh Credit Scoring UK Department of Trade and Industry (2005) Over-indebtedness in Britain A consumer is defined as being over-indebted if they meet one (or more) of the following: > 25% of income on unsecured loans > 50% of income on secured and unsecured loans 4+ credit commitments In arrears for more than 3 months Repayments: ‘a heavy burden’   How to Define Over-indebtedness?

9. University of Edinburgh Credit Scoring Economic theories including: Measured by the debt-service-to-income ratios There is the permanent income hypothesis (PIH), first developed by Milton Friedman. This theory tries to explain how an individual might spread their expenditure over their lifetime, taking into account, their expected future earnings – their permanent income. Therefore, it proposes that changes in expenditure will be generated by changes in the expected future income rather than by fluctuations in current income.     How to Define Over-indebtedness?

10. University of Edinburgh Credit Scoring UK Office for Fair Trading (2011) Irresponsible lending –OFT guidance for creditors “‘Assessing affordability’ […] is a ‘borrower-focussed test’ which involves a creditor assessing a borrower’s ability to undertake a specific credit commitment, or specific additional credit commitment, in a sustainable manner, without the borrower incurring (further) financial difficulties and/or experiencing adverse consequences” Financial Services Authority (2010) Mortgage Market Review: Responsible Lending “A mortgage is affordable if its level and terms allow the consumer to meet current and future payment obligations in full, without recourse to further debt relief or rescheduling, avoiding accumulation of arrears while allowing an acceptable level of consumption” How to Define Over-indebtedness?

11. University of Edinburgh Credit Scoring Here, we carry out an analysis of the applicant’s income and expenditure analysis to calculate disposable / free income.   This requires a lot of information from the applicant, and perhaps documentary proof. It is difficult to do and adds to the administration It adds to the sales process. It can be quite unreliable. It is only really referring to the present status. Changes may occur due to changes in income, expenditure, tax rates, and also due to the impact of the proposed borrowing. Assessing Affordability 1. The Traditional Approach

12. University of Edinburgh Credit Scoring In the UK, and in some other countries, there is the opportunity to use the information from the credit reference bureaux on the applicant’s existing credit commitments - on loan installments, credit card balances, etc. Some types of accounts are not included either partly or in total, e.g. current accounts, mortgages, credit union loans. It will be affected by individual financial lifestyles. Some people pay for food and travel and entertainment by credit card and others by cash or cheque, so there is a risk of double-counting or omission. It only looks at part of the picture. It is only really referring to the present status. Assessing Affordability 2. An Alternative Approach

13. University of Edinburgh Credit Scoring We build a statistical model, based on a sample of real cases, perhaps from the traditional approach. The inputs to the model would be factors such as gross annual income, number of children and marital status. These are captured already. Other factors may be included. The outputs from the model are the expected income after tax and other deductions, and the expected expenditure on lifestyle – food clothing, holidays, entertainment, etc. Requires info on total expenditure for a few hundred cases - but getting that information is a small price to bear for being able to avoid the borrower’s over-commitment and indebtedness. Assessing Affordability 3. The Modelling Approach

14. University of Edinburgh Credit Scoring We use a generic model from a bureau. As with most generic models, it has weaknesses:   It is based on data across the industry, and is not focused on your applicant base. It may not be clear exactly what data and from which banks / other lenders are included in the development. Assessing Affordability 4. The Generic Modelling Approach

15. University of Edinburgh Credit Scoring Here, the income is supplied by the applicant, but the expenditure figures come from central government statistics. In the UK, for example, there is the Expenditure and Food Survey. The data presented are the quintiles - i.e. where the top 20% begin, the next 20%, and so on. There are many detailed reports, analyzed by geographical region, age of the head of the household, number of people in the household, and employment status. This may not be segmented or targeted finely enough but may help to avoid the worst excesses / errors.       6. A Scoring Approach   This approach would be to include in the scorecard development affordability-type variables. However, empirical research has shown that these variables add very little over and above other non-affordability-type variables. If we could measure affordability, we may find it correlated with honesty, stability, and propensity.     We also need to be aware that our assessment of affordability may be different for different products. For a personal loan at a fixed rate, the monthly repayments and the term are known. For a credit cards the monthly repayments or the minimum monthly repayments can change, either through different usage, perhaps through changes to the limit, changes to the product terms regarding the minimum, varying interest rates, or changes A mortgage is similar to a loan although it may have a variable interest rate. Also, with a mortgage, they rarely go to the full term. Further, with flexible mortgages, the balance may not be predictable.   Assessing Affordability 5. An “Average” Approach

16. University of Edinburgh Credit Scoring In the scorecard development, we include affordability-type variables. Empirical research has shown that these variables add very little value / strength over and above other non-affordability-type variables. If we could measure affordability, we may find it correlated with honesty, stability, and propensity.   Assessing Affordability 6. A Scoring Approach

17. University of Edinburgh Credit Scoring We also need to be aware that our assessment of affordability may be different for different products. Personal loan at a fixed rate - the monthly repayments and the term are known. Credit card - the monthly repayments or the minimum monthly repayments can change, either through different usage, perhaps through changes to the limit, changes to the product terms regarding the minimum, varying interest rates, etc. Mortgage - may have a variable interest rate. Also, mortgages rarely go to the full term. Assessing Affordability

18. University of Edinburgh Credit Scoring Whichever way we choose to model or predict or assess affordability, it can really only assess affordability at the point of making a decision. It is difficult to factor in future credit commitments. The customer may apply for further credit and this is something that it is very difficult to factor into our assessment. When borrowers begin to have an affordability issue, we need to consider their hierarchy of payments. They may not think about this is such an explicit way, but they will have an order for their payments to be made. Affordability Hierarchy of Payments

19. University of Edinburgh Credit Scoring Affordability Hierarchy of Payments – One Model   Mortgage Car Loan Personal Loan / Credit Card Mail Order Mobile Phone

20. University of Edinburgh Credit Scoring There is now much greater public focus on the assessment of affordability. Lenders have always been concerned about this – as there has never been any sense in lending money to someone who cannot repay it.   Governments have become much more interested and are placing increasing burdens on the lenders to assess affordability. Affordability

21. University of Edinburgh Credit Scoring However, often missing is the balancing issue of the consumer taking responsibility for their own affairs and not applying for lending or for further lending that they cannot afford to repay. Whether governments are over-reacting to a few isolated cases or reacting sensibly to thousands of disadvantaged consumers does not alter the increased pressure being put on banks. Affordability

22. University of Edinburgh Credit Scoring None of the six approaches discussed would fully meet the current stricter codes and guidelines. There is now agreement / guidance that affordability assessment should be dynamic / forward-looking, and there is a recognised need to include some aspects of time. Affordability

23. University of Edinburgh Credit Scoring UK Financial Services Authority (2010) “We … require that the lender considers the variability of income over time in their assessment. ... When assessing affordability, lenders should consider the applicant’s ability to repay over the life of the loan.”, taking into account: Income and expenditure Reasonably expected future changes over the loan repayment period Credit sustainability from a long-term perspective Occasional missed payments Temporary (initial) inability to repay Affordability