The line between careful borrowing and unscrupulous lending is very fine, writes Bill Hobbs
In over two decades lending to ordinary people, I never once had someone tell me they couldn’t afford the loan they were looking for and not to give it to them.
Most people genuinely believe they can afford their use of credit. But they also have an exaggerated sense of personal safety – bad things only ever happen to other people. Guarding against this myopia is the stuff of good lending whether it’s banking, building society or the credit union type.
Can a person afford the repayments, what’s the risk of them not being able to and have they used credit wisely in the past are the key considerations.
Lenders rely on information provided by borrowers, who may decide not to reveal their true financial circumstances. Lenders get over this problem by using two mechanisms. The first is internal credit scoring, using statistical decision trees to rate borrowers as good risk or otherwise.
The second is using external credit reference agents to better understand a persons historic behaviour in using credit and predictive use of credit. At one time these agencies recorded previous behaviours. Today they also provide predictive information on how a person may behave in the future. Do these systems really work?
Only if the data used is reliable and provides a full a picture as possible of a persons credit profile. The outcome is said to lead to better lending decisions, more efficient cheaper processes and lower costs of credit. The good borrower is not forced to subsidise the bad borrower. There are also aspects of social engineering, getting people to behave as more rational borrowers. This is unfortunately the stuff of text book theory rather than human and social reality.
Central to the operation of a proper functioning consumer credit market is the ability of banks to be able to tell good risks from bad risks. Where they can’t tell the good from the bad they carefully ration credit. Where they can, they can charge less for good risks and more for bad risks. The Central Banks’ proposal for a national central credit reference agency illustrates the importance of ensuring banks can lend safely and people can access credit on affordable terms.
In future it’s likely that personal credit ratings will become a passport to living life as the citizen consumer. Those with poor or bad ratings will find themselves financially excluded, marginalised from accessing credit on affordable terms and forced to pay high rates to those willing to lend to them.
More intrusive central bank supervision of lenders and improved sharing of financial information may well create a shift back to the debt ethic of the past. A new form of citizen consumer who uses debt more carefully may emerge.
We once lived and worked our entire lives within tight knit local communities and lived as our neighbours did. Owing money was frowned on. Personal savings augmented with occasional small loans was how people funded larger purchases.
The twenty year mortgage, invented during the Great Depression in the US, was a means to make owning a home affordable to the masses. It took until the 80’s here before home ownership for everyone became possible. At about the same time the modern citizen consumer evolved. It was a consumerism that relied on borrowing to buy today rather than saving to buy tomorrow.
The consumer citizens’ behavioural use of credit shifted, driven by mass marketing that enticed people to live not as their neighbours did but to borrow to live like the rich do.
The better off were sold as the role model to emulate. The tight knit local community debt ethic became the global community credit ethic through mass media marketing. Once paid by cash or cheque, people’s salaries were paid electronically to bank accounts providing access to cash 24 hours a day. Money became bytes of data stored and transmitted across computer networks.
The physical value of the pound note became the click value of the online euro. As people needed bank accounts to pay for their consumption, banks cross sold credit cards, car loans, homeloans, holiday loans and anything that would generate fee income.
As disposable income improved, the consumer debt to income ratio expanded. More disposable income meant ever higher levels of borrowings which in turn drove incomes higher again.
Since the 80’s lenders invested little in understanding consumer credit risk. Instead vast sums were spent on driving down costs and increasing sales revenues. Counter staff were given sales targets. Lenders became relationship managers. The culture shifted from prudent lending to one that prized the successful salesman as a generation of traditional bankers were retired off. Banks are now busy getting back to the knitting of proper prudent lending and building the capacity to better understand and manage credit risk.
The perversity is to get the economy moving again, people have to start spending which means they have to start borrowing and behaving as boom time consumers. But banks won’t lend as they do not believe the risks are bankable. For the immediate future, credit will continue to be rationed and priced up, as banks cannot risk lending into a damaged economy.
Will there be a return to the pre-80’s debt ethic? Will most people once again save to spend later rather than borrow to consume today? It wouldn’t be such a bad thing. Modifying consumer behaviour sometimes takes extreme shock treatment – a credit crisis. But could it be, that having witnessed the car wreck and slowed down for a while, people will speed up again?
All the more reason then, for the Central Bank’s proposal for a national credit rating agency to be taken seriously. It may put manners on banker’s provision of credit and borrowers behavioural use of debt.
A version of this article appeared in the Irish Examiner Monday 5th July 2010, Business Section
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