Risk-Based Pricing Changing Lending?

Over the last several months, it seems risk-based pricing has been a hot topic in the Kenyan banking industry. Whether it be for mortgages, student loans, or small business financing, lenders need to understand how risk-based pricing works and how to use advanced analytics to set pricing and underwriting standards that customers can understand.

In this blog post, we provide an overview of the trends in today’s lending environment, who is driving them, and what they mean for every lender.

What is risk-based pricing?

A lender provides various interest rates and loan terms to borrowers based on their creditworthiness.That’s risk-based pricing.

For example:

A bank, sacco, or microfinance bank can offer a higher interest rate to a particular customer if they view them as a higher-risk borrower. That is, if the person was recently declared bankrupt, lost a job, or is several payments behind on a mortgage.

For the same exact loan:

The lender can also offer a lower interest rate if they view the customer as a lower risk. Say, the borrower has a good credit score and is probably employed.

Why’s Risk-Based Pricing so Much of a Concern to Lenders in Kenya?

Kenyan lenders have been pushing for the adoption of a risk-based loan pricing model since the Central Bank of Kenya (CBK) removed the rate cap to stop them from repricing their loans.

As a result, CBK raised the benchmark interest rate on September 29, 2022, giving 22 of the 38 commercial banks in the country the nod to increase their lending rates by 1.1%, effective from November last year.

And now, the highest loan rate, according to the latest industry data, is 15.7%, while the lowest is 7.02%.

See disclosures from the Kenya Bankers Association (KBA) on the same.

Although the interest rates charged by the majority of lenders will fall within a reasonable range, when other fees are taken into account, the entire cost of acquiring the same loan amount may differ significantly amongst the lenders. To make their products more competitive, however, most lenders are already opting to retain the old interest rates.

Increasing Rates for those who are Deemed Risky Borrowers?

Risk-based pricing is reshaping lending in Kenya, no doubt. Lenders are increasingly basing loan rates on a borrower’s credit score and other factors that they deem indicative of risk.

That means borrowers with lower credit scores and other risk factors will pay higher interest rates on their loans.

Some argue that this is unfair, as it penalizes those who may not have had the opportunity to build up their credit score.

Others say it’s simply the market at work—lenders are trying to minimize their risk. As a result, those who are deemed to be at greater risk are charged more.

Whatever one’s opinion on the matter, one thing is for sure: risk-based pricing is here to stay, and it’s already changing the landscape of lending in the country.

Lenders’ Criteria and Weight to Determine if Someone Is a High or Low Risk

When lenders assess lending risk, they’re essentially trying to determine the likelihood that a borrower will default on their loan. There are a number of different factors that can contribute to this determination, and each lender may weight these factors differently.

Some common risk assessment criteria include:

• Credit score: This is perhaps the most important factor in determining risk. A low credit score indicates a higher likelihood of default. However, a high credit score implies a lower risk.
• Employment history: Lenders see borrowers with a steady employment history as less risky than those who have been unemployed for long periods of time or who have had frequent job changes.
• Debt-to-income ratio: This measures how much of a borrower’s income is being devoted to paying off debts. A high debt-to-income ratio indicates that a borrower may have difficulty making loan payments, and is therefore considered riskier.
• Asset value: Borrowers with more assets typically pose less risk to lenders than those without any assets. This is because assets can be used to repay the loan if the borrower defaults.

Generally, most lenders are likely to use some combination of the above criteria to determine whether someone is a high or low risk borrower. However, the specific criteria used and their weighting vary from lender to lender.

How Can Lenders Better Assess Risk in Lending in the Advent of Risk-Based Pricing?

We understand lenders are under pressure to improve their lending practices in the wake of higher Non-Performing Loans. Moreover, the CBK risk model is expected to make credit more affordable to responsible borrowers and eventually enable them to achieve financial and life goals.

Consequently, lenders must find ways to better understand their customers and prospects to offer more tailored products and services.

Ideally, for that sliding scale of credit pricing to work, we must all agree that most lenders must have a better way to assess lending risk.

But that’s not what’s happening now.

So absent is a clear credit risk management system appropriate for an individual lender’s risk profile.

As a Checklist for an Automated Credit Risk Assessment System:

1. The credit scoring engine should automatically calculate the score of an application based on the information entered and the score card used.
2. Score card parameters should easily be changed with the built-in score card maintenance interface. The system should also support multiple score cards for different loan types.
3. The credit department should evaluate whether or not they’re using an appropriate or sophisticated credit risk assessment system suited to their risk assessment.
4. Automating credit scoring gives a better idea of how likely a loan applicant is to repay a loan.
5. Information obtained from risk analysis can be used to set interest rates that reflect the risk involved in lending to each borrower.
6. It’s easy to automate the process of setting prices, which can save time and improve efficiency.
7. It’s easy to identify patterns and trends that may not be apparent using traditional methods.
8. Monitoring customer behavior in real time helps to quickly identify and respond to changes in risk levels.
9.  Credit scoring provides customers with more transparency about how their data is used.
10. A smarter, more sophisticated credit scoring model can be enhanced to comply with evolving government regulation. This greatly favors borrower protection.
11. Low risk borrowers are able to get lower interest rates. High-risk borrowers may be able to get approved for a loan that they would have otherwise been denied.

For Internal Credit Checking

The system should interface with the lender’s internal system, thereby facilitating
retrieval of existing customers’ information. That is, customer information file, credit card, loans system, etc.

Manual credit scoring is a dead end…

It’s important to take into account the need for an automated credit scoring system that can lead to more accurate pricing and better lending decisions.

Learn more about our Credit Management System here

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