How the Credit Cycle, Credit Risk Cycle and Credit Risk Scores Interact
Yes, the word ‘credit’ is used quite a bit there, and it is used to describe three distinctly different elements, and yet all these elements impact one another. Let’s dig into these three terms, what they are and how they impact one another.
The Credit Cycle
The credit cycle describes access to credit. During economic expansions, it is easier to access credit, interest rates are lower, and credit limits are often higher than they might otherwise be.
Conversely, during periods of economic contraction, it is more difficult to access credit, interest rates tend to be higher, and credit limits tend to be more conservative(1).
Although credit cycles aren’t regular, you could think of them a bit like a wave, periods of expansion follow periods of contraction, and so on.
The Credit Risk Life Cycle
The credit risk life cycle is not the same thing as the credit cycle. As a junior analyst, I didn’t understand this, and was quite confused until I worked out that people were actually talking about two different things.
The credit risk life cycle refers to how consumer credit risks are managed. The credit risk life cycle starts with an application for a credit product. If the application is approved and the offer of credit is taken-up, then the account management portion of the life cycle takes over.
Account management refers to the credit risk activity and assessments that take place when the account is active. This includes credit limit management, authorisations management and card reissue (in the case of credit cards) or advances (in the case of revolving loans). Collections management is also part of account management, and occurs when payments are missed.
Until the account is either closed or written-off, the credit risk life cycle continues, and could find itself in various phases of the credit risk life cycle over the life time of the account.
The Credit Risk Manager needs to understand how the credit cycle impacts the credit risk life cycle and how, by changing scorecard cut-off scores, credit risk may be mitigated.
Let’s look at which types of scores are used at which point in the credit risk life cycle.
Credit Risk Scores
We use application scores at the point of application. Application scores can consist of demographic or bureau data, or some combination of the two. Organisations that do not have their own application score will often rely on bureau scores and information to make the credit decision. While this is a good way to mitigate for not having an application score, one major detraction is the fact that these organisations cannot assess risk for those individuals who do not have a credit bureau score, are only have very limited information at the bureau, which means that their bureau score may not be as predictive as expected.
Credit Limit Management
Credit limit management is a key component of account management. By ensuring that customers have appropriate credit limits, credit risk managers ensure that those customers with a strong propensity to spend and pay have appropriate limits, and those customers who may struggle to meet their payment obligations are not over extended.
Responsible lending obligations are a key component of credit limit setting, and credit risk is the other key component. In the same way that it is inappropriate to extend a customer’s limit beyond their means of paying, it is foolish to offer high credit limits to those customers who have a high propensity not to make payments.
Behaviour scores are used to manage the risk component of credit limit settings. Behaviour scores use the customer’s past performance to predict their likely future performance, and we usually predict how that customer is likely to behave in the upcoming 6 months.
Authorisations management (Auths) is used in credit card management to determine whether a transaction ought to be honoured. From a customer service point of view, an organisation may want to allow low risk customers who are a few days late on their payment the ability to still spend. Many organisations use rules to determine whether customers who are in very early arrears may continue to spend, however, it is best practice to use behaviour scoring.
Revolving loans products enable customers to draw down additional amounts provided they are managing their account well. In the same way that organisations may use policy rules to determine whether additional drawdowns are allowed, the use of behaviour scoring is best practice.
Collections or Arrears Management
When customers miss payments on their accounts, organisations mitigate that by collecting missed payments. Arrears management is a complex area and account management in the space is critical. Apply to aggressive a collections strategy to your best low risk customers and you may find that they repay any outstanding debt (yay! Job done), but promptly close their account and take any future spend to your competitor.
Similarly, by taking to gentle approach to your high-risk customer in arrears may well mean that outstanding amounts are not collected in a timely manner, resulting in increased arrears and bad debt.
Organisations can use behaviour scoring in arrears management strategies, or they could use collections scores. The key difference between behaviour scores and collections scores is the performance period.
Behaviour scores, as mentioned above, predict the likely performance over the next six months. Conversely, collections scores look at the likely hood that the account will roll to a higher level of delinquency in the following month.
Using scores that are appropriate to the part of the credit risk life cycle that you’re managing to crucial to ensuring the success of credit risk strategies.
Bringing it all together
As we’ve shown, diffident types of credit risk scores are best used at different points in the credit risk life cycle. The astute credit risk manager knows that as we move through credit cycles, organisations need to understand, not only which part of the credit cycle we’re in, but where we’re moving to. Credit risk managers can mitigate credit risk during contracting credit cycles by tightening cut-off scores. Similarly, as we move into an expansionary part of the credit cycle, the astute credit risk manager can take advantage of their credit risk scores by appropriately lowering cut-off scores to gradually take on more appropriate levels of risk (in line with the organisation’s risk appetite).