Credit risk in consumer finance

Why does credit risk matter?

Credit risk is fundamental to your organisation’s success. As well as helping prevent potential financial losses and repetitional damage, it ensures you stay compliant with strict regulatory requirements. More than this, however, it can be a powerful growth tool.

Consumer credit lending covers a wide range of industries and an even broader variety of product types. The risks involved when lending for a 25-year mortgage, for example, are very different from offering a short-term ‘buy now, pay later’ product. Because of this, understandably, there’s no one-size-fits-all approach for assessing and managing credit risk. So you need to use high-quality data and modelling tools to better understand who you’re lending to and how to segment them strategically. This in turn helps define your risk appetite and inform marketing and customer acquisition activities, which can fuel those growth ambitions.

Think of credit risk as a cyclical process, where each step informs the next, providing a continuous, data-driven framework to ensure responsible lending decisions.

How does consumer credit risk differ from commercial credit risk?

The balance between risk and growth appetite is at the heart of lending, whether you’re in the consumer or commercial space. However, there are fundamental differences between the two, such as who the borrower is, why they’re applying for credit, the data used to assess risk, and the regulations you must comply with.

To explore business lending considerations, such as how to assess a commercial client’s creditworthiness and what kinds of data to analyse, explore our commercial credit guide.

What is credit risk modelling?

Credit risk modelling is a data-driven process that helps you calculate the chances of a borrower defaulting on a credit product, and the financial loss this could create for your business.

It’s one of the key ways to assess and manage your company’s credit risk, allowing you to:

• predict the default risk of a new customer and assess how likely they are to make repayments.
• use a blend of quantitative and qualitative data to assess whether to approve or decline an applicant.
• monitor existing customer financial behaviours so you can proactively adjust credit limits, detect early warning signs of defaulting, and reduce exposure.
• spot growth opportunities, using sources such as Open Banking data and location insights to evaluate the creditworthiness of customers who may have been underserved or unscored elsewhere.

Secured and retail lending

Secured lending, such as mortgages, reduce credit risk by requiring the customer to provide collateral (i.e. the house) that you as a lender can repossess if they default on payments. Retail lending, such as ‘buy now, pay later’ products, is largely unsecured which means there’s no particular asset to repossess in case of default.

Both examples often involve high customer acceptance rates and smaller losses per person. Ultimately this means a diverse customer base for lenders to spread their risk across. That doesn’t mean this is a less riskier credit area, it simply means the ‘cost’ of lending isn’t always financial, and can sometimes look like lost opportunities, meaning the benefits you could have gained by approving the loan to another customer instead.

Credit risk in these areas is of course important, but marketing and sales strategies take centre stage here, as there’s such a fast and high turnover of credit products and borrowers.

With all that in mind, here are our best practice tips for secured and retail lending:

• Set your product and service prices according to your risk model to balance profitability and risk.
• Continuously monitor customer performance to adjust your credit limits and offers appropriately.
• Keep credit risk models updated to reflect new product types and market trends, and ensure the product proposition is attractive and the needs of your customers are being met.

Cards and loans

Credit cards provide a revolving line of credit that customers can use up to a certain limit. Risk is managed through that limit, as well as interest rates. Loans, such as mortgages, provide a lump sum that the customer repays in fixed installments over an agreed period.

Credit risk assessments for both products should look at the likelihood of default, repayment capacity, and a customer’s overall portfolio health. Behaviour credit scoring – which means assessing a person’s creditworthiness based on their financial habits – can also help you make informed lending decisions and manage ongoing risk exposure.

The most significant loss involved with card and loan defaults is a direct cash outflow. This makes risk management critical in order to maintain profitability. Here are some other best practice tips for cards and loans:

• Use a credit model approach when developing new lending products, to provide data-backed evidence that makes your products competitive.
• Implement automated credit scoring models to evaluate new applicants as these can provide improved acceptance accuracy and faster decision-making.
• Monitor existing customer accounts with behaviour scorecards to detect early warning signs that someone may be in financial difficulty and require additional or tailored support.
• Apply risk-based pricing to serve your higher-risk customer segments responsibly, ensuring business growth without a blanket risk.

Telecommunications

As an industry with high acceptance rates, the potential for financial loss in telecommunications is high. The focus here is primarily on marketing and customer acquisition, meaning credit risk is often a secondary concern as companies can better handle those smaller, more spread-out risks. Losses are largely opportunity costs as opposed to direct cash outflows.

Because of all of this, the balance of managing bad debt while achieving customer growth is a constant challenge. To help with this, we recommend:

• Incorporating basic credit checks upon new applications to prevent large-scale defaults.
• Continually tracking customer behaviours and payment history to stay updated on your level of risk exposure and flag any early warning signs of defaulting.
• Align your credit risk strategies with marketing goals to maximise growth opportunities without overexposure.