Towards The Future A high risk is not necessarily a bad risk
Pearce, Business Solutions Manager, Neural Technologies
Rapid change and increases
in competition are driving the financial market. Over the last few years,
the market has undergone significant changes due to the introduction of
the Internet, growth of e-commerce and the effects of the mortgage market
These changes are resulting in the diversification of the financial services
market. For example offering services such as mortgages and loans on-line,
fighting for customers through offering the lowest interest rates on credit
cards and highest interest rates on accounts. Due to the continual increase
in competition, the financial services are realising that there is significant
scope for profitable business in the sub-prime lending arena and that
high risk is not necessarily a bad risk.
The sub-prime market is becoming an ever more significant part of the
financial industrys future, estimated to be worth several billion
pounds per year and forecast to grow significantly.
Sub-prime means different things to different lenders. To most lenders,
sub-prime means an applicant from outside of the standard core
business with a perceived higher level of risk. For some companies, individuals
who have moved jobs more than three times in the last two years will be
sub-prime, while for many mortgage companies it may be the self-employed.
All of these have one area of similarity they could be excellent
risks. The person moving jobs could be a high earning company director
and the self-employed person may be a highly paid and successful consultant.
It is apparent from the above examples that some sub-prime risks may in
fact be highly profitable, even though they fail a companys rigid
rules for granting credit. These examples highlight the principle that
not all sub-prime risks are bad risks.
However, these are not the only risks that can be profitable, high risk
customers such as those with County Court Judgements or with past mortgage
arrears can also generate bottom-line improvements. At a time when over
25% of applications for credit and 30% of mortgage requests are refused
there is obviously a large market that is relatively under developed in
the UK. This is a fact recognised by one leading UK mortgage provider
who is said to be creating a sub prime division. When one
that the sub-prime market is estimated to be growing at 20 percent per
year, lenders approaching this sector with professionalism have enormous
potential for growth, from both a profit and customer base perspective.
Look to the US for vision of the future
In the US, sub-prime lending has been one of the fastest growing of
all industrial sectors. During the early 90s, the US sub-prime specialist
Green Tree grew at a compound rate of 83% on the New York Stock Exchange.
Competition in the US sub-prime mortgage lending market has also intensified
in recent years. Established mortgage providers such as GE Capital, KeyCorp
& Chase Manhatten are targeting the sub-prime market as well as companies
specialising in this particular market. The UK market is still behind
the US but is realising the benefits of being involved.
The sub-prime market in the UK has, to some extent, been ignored by UK
financial institutions, leaving the way for clear for US entrants to the
market. However, as blue-chip risks become harder to find and therefore
the margins on these loans erode, it is likely that more UK lenders will
look closely at the sub-prime market. Based on independent research during
1998, the UK sub-prime mortgage market alone was valued at £13 billion
and is still growing significantly to date.
However, lenders entering this market have to take a new approach to choosing
their customers. To maximise the potential in the sub-prime sector, lenders
need to assess each risk individually. For a company to enter the sub-prime
sector there are some decision-making hurdles to overcome:
presently using a manual underwriting approach to lending, a company
may not have the necessary expertise or resources to expand into this
using a combination of scorecards and underwriting, the present scorecard
may not be relevant to this new sector as it will not have been modelled
on this unique profile of customer
Looking Towards Technology
To succeed, organisations are already realising the need for more advanced
technology that can offer real time decision making that is both fast and
accurate, whilst facilitating assessment of the applicant as an individual.
Technology is playing a major role, as adaptive learning solutions, such
as Decider decision-support solution from Neural Technologies, ease
the sub-prime assessment risk. Decider produces bespoke scorecards
based on past lending decisions and results. It continually evolves by learning
from new data and the outcome of new lending decisions meaning it stays
constantly fresh and accurate.
Credit scoring has been in use for many years. This technology was introduced
to enable companies to overcome the problems associated with the underwriter
only approach to credit granting decisions. This is not to erode the
professionalism of any individual but merely states that additional benefits
can be achieved when underwriting expertise is directed to specific applications.
Credit scoring should not be thought of as the final decision-maker, it
is better thought of as a decision-support tool that helps an organisation
to better concentrate its underwriting resources. The main advantages of
implementing a credit scoring system are that it provides a company with:
decision-making by treating each risk individually
ability to concentrate underwriting resources on the marginal cases
flexibility so that customers and/or products can be segmented. This
is especially useful when cross-selling other products or services
Growing competition means future financial institutions that will only
lend to class A or low risks will find it hard to succeed in the UK or the
increasingly global market place, without drastically cutting margins. Sub-prime
lending provides a high growth opportunity for UK institutions and can be
In America, sub-prime lending is the industrys fastest growing sector.
The sub-prime market in the US is estimated to be $60 billion with an annual
growth of 15%. It is expected that the UK market will grow at least as quickly,
perhaps more so, as the UK is, by comparison, a relatively under developed
market for sub-prime lending. Some commentators also suspect that mainstream
credit scoring systems have not kept up with the structural changes that
took place in the employment market since the recession of the early 1990s.
This means that many more people fall into the sub-prime market than may
be strictly necessary.
The most important message is that a high risk does not necessarily
mean a bad risk. However, any company entering this market
will have to change its underwriting approach. An adaptive credit scoring
approach has the capabilities to aid the credit granting decision-making
process and can help any company entering what is going to be a fast growing
and highly profitable sector of the credit industry.