Written by Jeff Keltner, SVP Business Development
In times of macroeconomic disruption, such as the COVID-19 pandemic, banks and credit unions tend to tighten their credit standards. However, this may not be the best approach for lenders or their customers and members.
The problem with tightening credit
Tightening credit standards typically means that a lending institution raises the minimum score its borrowers need to obtain credit or lowers its maximum debt-to-income ratio requirement. It could also involve increasing the cost of credit in rate tables.
While these may be rational responses when a macroeconomic disruption occurs, they aren’t ideal. They’re rough and imprecise approximations of what a lender might be looking for, which can ultimately impact more borrowers than necessary.
A better solution: an individualized risk model
A better alternative may be a more sophisticated model that makes risk-based predictions on an individual level. Using this model, lenders can answer a couple of vital questions:
- Is the same consumer today riskier than they were before the macroeconomic disruption?
- What’s the lender’s risk tolerance?
Unfortunately, most credit tightening policies assume a direct link between an applicant’s risk and their credit score. Evidence from the current pandemic shows that raising credit score requirements and reducing the maximum DTI ratio were metrics that didn’t correlate well to the need for deferral or forbearance programs.
Borrower risk level
The first question determines if the applicant is more likely to be affected by the disruption. Are they more likely to default or not repay their loan obligation than before?
Unfortunately, most credit tightening policies assume a direct link between an applicant’s risk and their credit score. Evidence from the current pandemic shows that raising credit score requirements and reducing the maximum DTI ratio were metrics that didn’t correlate well to the need for deferral or forbearance programs. They aren’t necessarily a well-targeted approach for managing risk in times of economic stress.
A solid individualized risk model can account for increased risk. It can see that the borrower’s risk has increased because the world is riskier. That enables lenders to understand and appropriately price or limit the risk they’re willing to assume. The results are a natural limiting of approvals and an increase in interest rates charged.
Lender risk tolerance
The second question seeks to answer if the lender is willing to assume the same risk now as they were before. If they were willing to take losses up to a specified amount before the disruption, are their loss tolerances now lower?
Once a lending institution increases its risk assessment, interest rates will rise. That occurs even without an adjustment to the institution’s returns strategy. However, the lender may also want to consider if there’s a need for higher returns at a given risk level in more uncertain times.
Quantifying and pricing risk more effectively
More advanced individualized risk modeling and credit underwriting techniques allow lenders to separate the above questions and their corresponding answers. In turn, those lenders can respond in more targeted and effective ways during times of macroeconomic disruption. It’s a solution that has benefits for both lenders and borrowers.