How can lenders benefit from the rise of responsible lending?
The purpose of lending
Lending. Put simply; lending is the act of giving money with the agreement that it will be paid back later, with an extra amount paid as interest for the favour. Simple, right? Of course, as anyone who has gone to the bank recently knows, there is much more to the equation. How much do you want to borrow? What is the interest rate going to be? Will you pay the money back on time, or will you run off into the sunset?
The subject of fair and responsible lending is a complicated one. On one side is the bank, which ultimately needs to turn a profit focusing on reducing risk while maximising profit. On the other side is the individual (or company) who needs to have easy access to loans, so they have the opportunity to buy a car to drive to work, for example, and to ensure economic growth. But not all individuals are equally reliable.
What is fair between consumers and lenders? How can we strike a happy balance?
To understand the purpose of lending, consider Muhammad Yunus. A Bangladeshi civil society leader who was awarded the Nobel Peace Prize for pioneering the concepts of microcredit and microfinance. Yunus sees lending as a fundamental human right, and he believes the main objective of lending is not to make lots of money but to help lift individuals out of poverty. Lending is a powerful tool to bring about social and economic development: “Lend the poor money in amounts which suit them,” claims Yunus, “teach them a few basic financial principles, and they generally manage on their own”.
“In amounts that suit them” means lending that is beneficial for the customer. Historically this involved finding out what a loan was to be used for – a house, a new boat, or for consolidating debt, for example. Now, however, figuring out if a loan is “beneficial” has become equated with determining if a person has the financial means to repay the loan. There is far less time spent discussing what the loan is for than the terms on which it will be paid back. Is a series of drop-down menus sufficient for determining if a loan amount is suitable?
Somewhere along the way, the human purpose of a loan has been lost.
The issues of responsibility in modern-day lending
The lending landscape has changed significantly in recent years, with many lending more liberally. As competition heated up in the marketplace, lenders have been giving out more loans, even if this increases the proportion of defaults.
A recent report from Finansinspektionen stated that 3.2% of all borrowers in Sweden receive at least one injunction to pay over a year. A considerable amount given that in 2021 lending to households amounted to SEK 4 658 billion. The assumption that a significant proportion of loans will not be paid back is built into the fundamentals of many risk models. As long as a large enough portion will be paid back, a small number of defaults is OK, provided the interest rate is high enough.
It is up to the lender to set what percentage of loan default is acceptable depending on their risk appetite and historical repayment rates. While lenders could use this information to improve their credit scoring models and reduce defaults, mostly, this data is used to maximise profits.
What does it mean for a bank to lend responsibly?
Responsible lending has become a top priority for many financial bodies, with new rules coming out to encourage consumer-friendly lending. For example, the new EBA regulation ensures that an individual’s total loan repayment costs are lower than current repayment costs for consolidation loans. In this way, being good for the consumer is not too controversial because it is built into how banks assess borrowers. But there is a balance between consumer fairness and business profitability, of course.
To reach this balance of responsible lending, we need to remove the bells and whistles of modern-day lending for a moment and take a step back to the basics:
- Transparency – to be consumer-friendly is to make everything as straightforward, open, and as easy to use as possible. This means no hidden fees, no lengthy convoluted contracts, and no disingenuous sales processes. Having the system be transparent is key to ensuring economic prosperity.
- Sustainability: For a long time, banks have been talking about the customer experience. However, now, banks are talking less about pleasing millennials and matching current trends and more and more about what it means to lend to the right people and build a sustainable business model along the way. Issues such as Environmental, Social and Governance (ESG) considerations have replaced the need to have the best customer experience and will be an essential part of the banking sector’s future.
- Stick to the facts – In the past decade, there has been significant focus on the superficial elements of lending, like having the prettiest app or the slickest website. But don’t forget that at the end of the day, people mostly care about how fast they get a response and about a lender’s interest rates. Banks are shifting their focus to lending responsibility, not just the UX.
- Less paperwork – Manual processes are slow. There’s no doubt about it. The burden of time-consuming paperwork seems a far cry from the simple act of lending money. Companies with a modern-day approach know that rebuilding the economy can be done much more efficiently by embracing digitisation, helping to simplify the process for consumers and keep costs down. Plus, automation helps tremendously with understanding if a company or person would benefit from a loan (and be able to pay it back) which is paramount to creating a healthy lending portfolio.
- Fairness – Traditional loans can be biased against some individuals who may otherwise prove to be good customers. Newer systems embracing digitisation and alternative data such as PSD2 data can vastly improve the fairness of the lending landscape. The more data you include in credit scoring, the more responsible your lending will be because you can better predict if a person can repay.
The future of lending responsibly
Getting back to basics might seem like a step backwards. But it is not. Not with all the knowledge we have learned over the past few decades. A focus on the core product is precisely what is needed for responsible lending. Not a focus on the latest web design or the flashiest social media page. Now is the time to be thorough and get back to the heart of why banks lend: to help people grow.
As we come out of the pandemic, there are good businesses and responsible people who need financial support, and there is an excellent opportunity for banks and lenders to get new clients that would typically not need a loan at all. And it is possible to do this responsibly, all while growing your business. The demand is there for the taking.
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The subject of fair and responsible lending is a complicated one. Somewhere along the way, the human purpose of lending has been distorted. Taking a step back towards basics might seem unintuitive when it comes to responsible lending but it is exactly what is needed.