by Amit Kumar, Senior Consultant
Assessing the creditworthiness of customers during a credit application has always been at the forefront of the lending industry.
Lending decisions – the traditional tools
For banks and other lenders, there are numerous ways an application is assessed, and a decision on whether to lend, or not lend, is made following certain steps. The key step in the lending decisions is to pass the application through the lending institutions’ verification process, credit policies and application/bureau score strategies. Application scores are calculations used to assess the credit worthiness of the customer through a score which points to a likelihood of the customer defaulting on the payment in the next 12 months. The actual definition of default varies from lender to lender and product to product. Usually an event where a customer has missed three or more continuous payments is flagged as default. The credit bureau scores, where available, play an important role in helping the lender understand the performance of the customer on lending products of other lenders. Generally, a high application score and a high credit bureau score correspond to good credit behaviour.
In addition to above, another important factor that is considered during the lending process is the affordability of the customer. The traditional way of measuring the affordability aspect is the Debt Burden Ratio (DBR), which is calculated as a ratio of the total monthly debt payments that the customer is making against the customer’s total income. A lower DBR corresponds to a high affordability and vice-versa. In calculating DBR, the total debt payment of the customer with the lender and other lenders is added to calculate the numerator of the ratio. The central bank plays an important role in setting up policies with regards to DBR thresholds for each lending product type, and the lending institutions are asked to approve applications which do not cross the DBR threshold for respective products.
While the DBR gives a fair understanding of the additional equity left with the customer from debt payment perspective, it does not consider a customer’s other non-credit obligations. These additional obligations are vitally important in order to understand the sustainability aspect of the customer from a credit point of view. Non-credit obligations include lifestyle expenses such as rent, food, education, insurance premiums, transport, communication, utility expenses etc. These are necessary and unavoidable expenses which every person must manage in their daily lives. For example, a customer with a monthly salary of 10,000 has a monthly credit commitment of 4,000, which corresponds to a 40% DBR that might fall within the threshold prescribed by the central bank. However, if this customer has a large family to support and his monthly non-credit commitments are 6,500, the total monthly expense for the customer comes out to be 10,500 which is higher than his monthly salary. This is a classic example where the customer will face challenges in meeting their monthly obligations and may even default on some of the payments.
Therefore, from a responsible lending and credit risk perspective, it is extremely important for lenders to assess the affordability of a customer from a sustainability perspective by considering their non-credit obligations in the decision-making process.
The next generation – mathematical models
Qarar’s Affordability Calculator is a mathematical model developed and based on several publicly available data sources from the Government; it greatly helps banks calculate the affordability index for a customer and for each application. As a must-have risk-management tool, the Affordability Calculator helps the credit risk management teams be far better informed in managing risk. Another important factor to take into consideration is banks who implement the Affordability Calculator will be automatically compliant with some of the recently introduced central bank regulations in the Middle East.
How the Affordability Calculator works is that is that it takes into consideration a list of vital demographic information, most of which is readily available at the time of application. It calculates the customer’s expected non-credit obligations, which lenders can factor into the lending process in addition to the DBR thresholds.