Risk-based pricing of loans in India: the shape of things to come?
Recently, a leading Indian Bank announced plans to price retail loans based on consumers’ credit scores. This means that loan seekers with strong financials and a good loan repayment track record should get loans at lower rates.
While common in other parts of the world, and common in corporate lending the move is innovative for retail lending in India. At present, credit scores – whether driven from external credit bureaus or internal bank models – are only used to decide whether to approve or reject the loan application. The interest rate charged on the retail loan has not been driven by the score. Why have banks used it for corporate lending and not for retail lending? Perhaps it is because of power – after all big corporates seeking large loans have much stronger negotiating positions than retail consumers. Perhaps it has been driven by market segmentation strategies – where lower margin corporate loans have been subsidised by higher margin retail loans.
However, over the last couple of years, with the sluggishness in corporate lending banks have shifted focus to the retail segment to drive growth. The retail market is rapidly changing, presenting a new set of challenges and opportunities. The opportunity is big. As per an estimate by Credit Suisse, India’s retail loan assets, including SME credit, will grow to $3 trillion by 2026, five times the size of the market now. At the same time, the levels of competitive intensity are constantly increasing – banks versus banks as well as aggressive NBFCs. As digitisation accelerates, the battle to acquire customers is expected to further heat up with peer-to-peer lenders and Fin Tech startups making life even more challenging for banks. In the headlong dash for growth banks need to exercise caution as delinquencies can soon pile up, especially if growth is not backed by robust credit practices. Risk-based pricing of loans can play a very strong role in this context.
Research suggests that a risk-based pricing environment based on accurate credit information can improve loan performance by reducing delinquency rates. Also, with the ability to tailor prices, lenders can extend credit to more consumers, profitably. Instead of rejecting applicants who pose a default risk of say 5%, lenders could accept them and charge an appropriately higher price for the loan to cover the additional risk. High-risk borrowers are therefore no longer subsidised by lower-risk consumers. Lenders who tailor their pricing to match the costs for each segment can compete much more effectively by offering each segment the lowest price in line with the costs of providing the loans.
Differential loan pricing based on the credit worthiness of loan applicants is commonplace in countries such as the US and UK, where consumers actively use credit scores to seek out better deals. Their credit score dictates the interest they pay on credit cards and loans; so every consumer is conscious about their credit score. Moreover, unlike in India, only the most glaring defaulters get shut out of the credit system; the rest simply pay higher interest rates. The fact that good borrowers get better credit rates has probably been responsible for widespread awareness about credit information reports, especially since lenders aggressively market their loan offerings on this basis.
A part of reason why it has not kicked off as yet in India can be attributed to the fact that credit bureaus are relatively recent in India as compared to mature markets like US, UK, South Africa, Hong Kong etc. where they have existed for 50 to 100 years or even more. Modern retail lending is barely two decades old in India, and Indian banks still lag behind their western counterparts, in adopting analytics and risk prediction models. However, this provides them with an advantage, they can leverage best practices, build on experiences in other parts of the world and avoid the common pitfalls. To offer differential pricing banks will need to utilise data from credit information bureaus more dynamically. The information shared by the credit bureaus when coupled with advanced predictive analytics solutions can help lenders with better loan pricing and risk management capabilities. Today specialised lending solutions are available which offer sophisticated analytics-backed credit scoring models, ability to build extensive credit score cards, flexibility in defining rules and policies, along with providing seamless integration with credit bureaus.
At present just one bank has announced its plans for risk-based pricing, but it seems obvious that others will follow. When that happens, it will be a win-win for all the stakeholders. By attracting high creditworthy customers, banks will reduce the risk and improve the quality of their retail portfolio. Consumers with good credit scores will benefit from cheaper loans. Consumers with relatively poorer credit scores have strong incentives to improve their credit profiles, while still availing of higher cost loans in the short term. The industry also stands to gain by adopting a mature retail lending practice which will help in driving business growth, increasing credit penetration and enhancing financial inclusion.