Breaking New Ground: Navigating Personal Lending for Underserved Segments (Part 2 of 2)

Introduction

There are multiple barriers to financial inclusion in the UK’s personal lending space. As a seemingly unsustainable trend towards using credit to pay for necessities continues to grow, banks become more cautious about borrowers who lack verifiable or strong credit histories particularly those with limited affordability, non-standard income (e.g., the self-employed), immigrants, or individuals whose poor credit scores stem from life events such as the loss of a job, health issues, or a divorce.

In our previous blog, we explored the business case for serving these underserved segments. Echoing the spirit of Jeremy Clarkson’s Amazon Prime television show ‘Farming the Unfarmed,’ where unused farmland was regenerated and used to grow new crops, they remain largely untapped yet ripe for cultivation by forward-thinking banks. However, barriers such as rigid affordability checks, legacy systems, and heightened credit risk may pose challenges. But now is the time to act, as competitive pressures and economic shifts are reshaping the lending landscape. In this second instalment of a two-part blog series, we share lessons from around the world that illustrate how advanced technologies, tailored lending practices, product innovation and financial literacy can converge to expand access to responsible lending for the good of society.

Barriers to Personal Lending

Banks face specific challenges in personal lending, particularly when it comes to demonstrating the affordability of these borrowers and managing back book quality. The risk appetite of the bank will be influenced by a range of factors, including wider macroeconomic conditions and the prevailing regulatory environment as well as leadership strategy and the underlying capital and liquidity position of the institution in question. Lending to individuals with poor credit histories can therefore be problematic, primarily due to the heightened risk of default as well as the increased regulatory capital the bank must hold to offset the risk of losses. Beyond these fundamentals, there are also other factors contributing to the reluctance of lenders in this space, including:

1. Data Limitations in Affordability Assessments

Banks are obligated to demonstrate that lending is affordable, relying on evidence from customers and credit reference agencies. However, accurately assessing borrower affordability can often be hampered by insufficient data, particularly for those customers with limited or otherwise ‘non-traditional’ credit histories. Indeed, many individuals, especially those new to the UK or with patterns of irregular financial activity, may lack a sufficient credit “footprint” for the bank to confidently assess creditworthiness, making it more difficult for banks to extend credit.

2. Regulatory Concerns

The Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) both rigorously oversee lending practices, focusing on customer protection in areas such as affordability and suitability as well as enforcing capital adequacy rules. Besides the potential for credit losses, these requirements for capital reserves and the need for enhanced risk management practices add operational burdens that make banks more cautious about expanding beyond prime borrowers. Additionally, launching new products or entering new segments may mean advanced credit models cannot immediately be applied creating an incentive for stability that seems to preserve the status quo.

The challenge for banks then is threefold, in that they must be able to:

• put the right proportion of their balance sheet to work as earning assets in a way consistent with their risk appetite;
• provide services to customers in a way that supports financial inclusion without adversely increasing risk; and
• ensure they remain fully compliant with customer protection and capital regulations.

Nevertheless, despite these barriers, the regulatory landscape also presents an opportunity for differentiation. Rather than viewing these regulations solely as obstacles, banks can also seize the opportunity presented by the latest technologies to innovate. Indeed, through canny innovation, banks can successfully operate inside existing regulatory frameworks in ways that balance the need for financial inclusion with the demands of careful risk management.

The Path Forward

In Clarkson’s Farm, the titular star transformed untapped, unfarmed land by carefully identifying and cultivating the most promising plots, demonstrating that innovative approaches can yield success even after initial setbacksⁱ. His persistence in exploring new farming ventures ultimately pays off. And UK banks too may find opportunities in the less ploughed financial furrows including the large segment of underserved customers who are already using some form of transaction or payment service and accessing some kind of credit outside traditional banking systems.

Evolving economic realities and heightened competition make it imperative for banks to reexamine their lending strategies now. Institutions committed to widening financial inclusion can consider the practical tips below, which are geared to help them extend their services into the underbanked customer segments and potentially capture long-term sustainable growth.

1. Lost Opportunity Analysis 

Lenders should collaborate proactively, through careful data sharing, with leading credit bureau and other lenders to track whether previously rejected clients have been accepted by other institutions, and how those loans performed (e.g., were they repaid on time, or did they result in default?). This can provide valuable insight for banks, helping to identify missed opportunities and potential revenue losses as well as allowing institutions to dynamically hone their lending criteria and decision-making processes as they go. 

2. Leveraging Data-Driven Approaches from Subprime Lenders

Banks specialising in subprime lending often have extensive data on defaults and losses, allowing them to develop precise risk assessment models. Mainstream banks can adopt similar data-driven approaches by harnessing their own default data to identify previously unknown patterns in behaviour as well as potentially tapping other sources of structured and unstructured data (see next point). In doing so, this helps banks more accurately identify borrowers who present a higher risk of default and identify profitable borrowers who might otherwise be overlooked.

3. Utilising Alternative Data Sources

Open Banking data, telecoms and other utility payments, retail interactions and other alternative data sources can all be leveraged to enhance credit risk profiling. Such data points provide a broader understanding of a consumer's financial habits. For instance, models using Open Banking data have been shown to predict default risks effectively, outperforming conventional credit scoring systems when combined with traditional dataⁱⁱ. Additionally, transaction and spending data could be leveraged in credit risk assessments, allowing banks to gauge financial health and spending patterns more accurately. For example, one large US technology provider has demonstrated how data gleaned from its marketplace on sales patterns and balances can help them make precise lending decisions to support those same small business customers selling on its platformⁱⁱⁱ.

4. Enhancing the Operating Model

Legacy infrastructure and processes can slow established banks, leaving them vulnerable to agile challengers. Banks should consider modernising their operating models by streamlining processes, introducing innovative products, enhancing marketing strategies, and broadening distribution channels. These changes not only protect against market disruptors but also position banks to better serve underserved segments efficiently and competitively.

Learning from Global Best Practices

• A common theme found in the US, Netherlands, Mexico, and India is an emphasis on financial literacy to support financial inclusion. While some UK banks have commendable programs, these initiatives could be expanded still further to provide more in-depth education on credit risk, borrowing, and financial management. UK banks should consider developing targeted financial literacy programmes catering to specific customer segments, enhancing overall financial understanding and inclusion.
• Meanwhile, the Netherlands has developed a collaborative model for personal lending, integrating banks, government bodies, financial institutions, and fintech companies to offer comprehensive financial support. This collaboration enables detailed borrower profiling by combining data from utility providers, government programs, as well as traditional credit histories, allowing for more precise risk assessments. One key element is the proactive, bank-led debt assistance route, which shifts the focus from transactional lending to a more relationship-driven approach that seeks to improve the long-term financial health of customers^iv,v.
• In the US, the Community Reinvestment Act (CRA) enforces strict lending criteria for personal loans, ensuring financial inclusivity alongside effective risk assessments^vi. Although not directly applicable to UK banks, the principles of the CRA demonstrate how tailoring personal loans to meet diverse individual and community needs can be delivered in a responsible and risk aware manner to the benefit of all parties^vi.

Leveraging insights like these can bring predictive power to the way risks are assessed, rendering this higher-risk sector less daunting for mainstream financial institutions to address. This approach should be utilised alongside responsible lending principles, ensuring that risk assessments are not only accurate but also fair.

Conclusion 

Mr Clarkson’s journey to restore unfarmed land to a source of value and profit offers an inspiring vision that UK banks may wish to think on as they consider the innovative strategies they themselves might adopt in lending to the underbanked in a sustainable way. In today’s environment, competitive pressures from fintech companies and alternative lenders, combined with economic shift such as interest rates and evolving consumer behaviours, provide strong motivations for banks to reexamine their products, portfolios, and lending strategies. By reviewing these approaches and navigating barriers, banks can enhance financial inclusion and achieve sustainable growth. 

For further discussion on these insights, please contact us.

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References

i. Clarkson’s Farm Season 3 review: A real & authentic look at British farming (2024). Available at: https://www.flickonclick.com/clarksons-farm-season-3-review-a-real-authentic-look-at-british-farming/ (Accessed: 08 July 2024).

ii. Hjelkrem LO, de Lange PE, Nesset E. The Value of Open Banking Data for Application Credit Scoring: Case Study of a Norwegian Bank. Journal of Risk and Financial Management. 2022; 15(12):597. https://doi.org/10.3390/jrfm15120597

iii. Amazon taps merchant data to grow lending business: Finextra.com. Available at: https://www.finextra.com/newsarticle/30672/amazon-taps-merchant-data-to-grow-lending-business [Accessed: 22 August 2024].

iv. Working Together for a Financially Healthy Netherlands: The Dutch Debt Relief Route (no date) Dutch Debt Relief Route. Available at: https://nederlandseschuldhulproute.nl/ [Accessed: 22 May 2024].

v. Types of Loans in The Netherlands: The 8 Most Common Loans (netherlandsexpat.nl) https://netherlandsexpat.nl/loans-in-the-netherlands/ [Accessed: 22 May 2024].

vi. Community Reinvestment Act." Office of the Comptroller of the Currency. Accessed May 26, 2023. Available at: https://www.occ.gov/publications-and-resources/publications/community-affairs/community-developments-fact-sheets/pub-fact-sheet-cra-reinvestment-act-mar-2014.pdf.