Being able to effectively manage risk is one of the most important tasks for successful banks. Generally, credit loans are a bank's most pronounced source of risk, while simultaneously being one of its main sources of revenue. Thus, competent risk management in credit and lending is essential to the overall financial health of a banking institution. The approach that banks need to take towards credit risk management should be holistic, and requires them to be flexible in order to respond adequately to changing individual and market conditions.
A variety of factors must be taken into account when considering risk management in the credit lending process, ranging from the bank’s entire portfolio overview down to the individual customer’s transactional level. In order to do this, and do this well, there are a considerable number of elements that banks need to consider. Increasingly banks are feeling the pressure to make credit and lending decisions faster than ever before. In the face of the digital revolution as well as the recent emergence of Open Banking, banks have to work harder than ever to remain competitive in the dramatically changing European (and global) financial landscape.
The credit lending process is vastly complex and multifaceted. It requires the competent coordination of various internal banking levels and organizational units. The process begins at the sales level and then quickly expands to encompass data collection, review, credit assessment, risk analysis, documentation and collateral, before finally leading to the approval or rejection phase. Once a decision has been made, then the processing phase begins and implementation of the credit decision can take place. All of these different factors have to be coordinated across various internal segments of the bank, and are expected to happen relatively quickly and accurately. Mistakes can result in the loss of revenue.
Source: Oesterreichische Nationalbank
Not only are banks expected to go through a risk assessment process at the initial application process, but they must also continually reassess the risk probability of loans that have already been approved. Of particular importance is the need to continually update customer data so that key changes in position can be taken into account. “Effective risk management is only possible if the relevant information is passed on to the decision makers in a timely manner. This has to be safeguarded by the [IT] systems. Ultimately, systems should be able to initiate information and management processes automatically.” Continual monitoring and reporting processes need to be streamlined within banks to properly manage risk within the financial institution. “Risk management is thus a continuous process to increase transparency and to manage risks.”
Source: Oesterreichische Nationalbank
Digitization is drastically changing the credit and lending processes within banks. Banks have come to realize that there are various challenges as well as opportunities that digitization can present to their organizations. While “a digitized risk function provides better monitoring and control and more effective regulatory compliance,” it can be complicated for banks to overhaul their systems and become fully digital.
Some of the most important pain points that banks face when trying to respond to digitization in the credit risk and lending industries include: IT and data constraints (i.e. legacy IT systems, poor data quality, etc.), outdated credit risk assessment systems, overly long wait times for loans, a conservative culture of risk managers, complex internal organizational structures, heightened levels of fraud, and increasingly complicated regulations. In addition, the rise of Fintechs and other competing entities that are smaller and more adaptable to market conditions, pose a great concern to more traditional financial institutions that respond more slowly to changes. Furthermore, there has been a shift in how (in)tolerant the public is towards any occurrence of preventable errors and/or inappropriate business practices by banks. Existing bank structures (i.e. information asymmetries, barriers to switching, unclear advice, nontransparent or overly complex pricing structures) are also coming under stronger review. Finally, governments are strengthening how they police illegal and unethical behavior (i.e. financial crime, tax avoidance, terrorism funding, money laundering). As a response to all of these different factors, many banks are overhauling their entire approaches to risk.
While for some financial institutions, altering how they approach risk management is a practice in compliance, for others it is seen as an opportunity to improve their performance, customer service, and competitive advantage in the industry. “At an average commercial bank, credit-related assets produce about 40 percent of total revenues… Well-designed credit processes can reduce operating expenses by 15 to 20 percent and risk costs by more than 20 percent, while improving customer experience.” As new types of risk emerge due to digitization (cyber, contagion, etc.), new skills and tools need to be developed in a way that does not substantially increase the bank’s operational costs.
Traditional credit review process are based on external and internal data that exists about the applicant. Generally, “considerable resources may be tied up in the process of collecting the data, checking the data for completeness and plausibility, and passing on the data to people in charge of handling, analyzing, and processing the exposure within the bank.” Because of the complexity of these processes, procedural errors are common if not to be expected.
In order to improve their existing systems and procedures, banks are increasingly turning towards deep analytics to digitize their risk systems. Some of the ways in which the are doing this include: automating credit decisions, digitizing underwriting processes, using machine-learning techniques to improve existing procedures, creating and accessing data lakes and/or unstructured data sources, and interactive or alternative risk reporting and scoring.
In order for banks to successfully redesign and digitize their credit risk processes, there are several things that they need to do. “The starting point is a set of colocated, cross-functional, full-time, dedicated teams empowered with decision-making authority and tasked to deliver products on deadline,” otherwise known as agile project delivery. They need to structure their project goals around the seven most important building blocks for digitising risk management which include: data management, advanced analytics and automated decision making, smart interfaces, culture, workflow automation, flexible infrastructure, and external ecosystem. Lastly, when they do decide to partner with other organizations, they need to ensure that the solutions being offered are genuinely valuable to the overall project goals. If they keep things in mind when planning their risk management transformations, they will be better set up for success. Digitizing their back and front office capabilities, as well as unique digital services offered to customers will give them a competitive advantage.
There are two parts of the credit and lending process that have the most urgent need to be digitized: sales and legacy IT systems. Many banks are turning to Fintechs to aid them in the process of digitizing their organizations. Although, some Fintechs have emerged as major competitors to traditional financial institutions (generally B2C companies that are trying to take over the most profitable aspect of a bank’s value chain: the direct relationship with the customer), many Fintechs are not interested in replacing banks. Rather, they are working directly with the banks in a variety of credit and lending industry subcategories to resolve issues and create innovative solutions.
“Over 80 percent of top global banks have some form of partnerships with fintechs, of which 16 percent are related to lending.” Examples of services that startups are offering include: API integration and platforms, mobile banking apps, business and SME banking services and loans, car financing, digital banking, student loans and financing, fraud detection, prevention, and response, creditworthiness assessment, credit scoring, P2P lending, B2B loans, and short-term cash advances, among others.
Much of what startups are doing is completely digital and extremely innovative. They are able to address specific pain points for banks, both on the consumer side of things, but also for the internal organizational side of things. For consumers, they are able to much more effectively offer specific services to underserved segments of the population, providing a better experience and addressing individual customer needs. Because digital channels have become the norm for credit and lending processes, it is incredibly important for banks to continually offer new digital capabilities, or risk disappointing their customer base. Thus, the most useful solutions for traditional banks include digital loan platforms and mobile banking systems.
On the internal side of things, Fintechs are able to help banks harness their existing data in order to improve in-house systems. Usually they are able to do this faster and cheaper than banks would be able to do on their own. This is a key part of continuous risk mitigation for banks. Thus, the most useful solutions for traditional banks include automated credit decisions based on alternative credit data, API integration systems, and the restructuring of existing data and legacy systems so that it can be used with advanced data analytics and AI systems. Working with Fintechs is one viable and readily available solution for banks to consider when deciding how to innovate.
Digitization is not an easy or quick process, but it is essential given the current global financial landscape. “Most institutions are digitizing their risk functions at a relatively slow pace, taking modular approaches to targeted areas. A few have undertaken large-scale transformation, achieving significant and sustainable advances in both efficiency and effectiveness.” We no longer exist in a world where a bank who does not innovate and digitize can be successful.
How banks choose to digitize their risk management systems is something that they have to determine for themselves. However, it seems clear that those who put the time, money, and effort into digitizing their systems will benefit exponentially in the long run. The digital revolution and development of Open Banking systems in Europe, have put banks under pressure to digitize their systems. This is the key, not only in order to remain compliant with new regulations, but also to increasing revenue, reducing fraud, and keeping customers happy.