The credit pyramid

Mortgage lenders can achieve high performance through the current downturn by being flexible and proactively helping customers navigate their way through their own interlinked debt hierarchy. Peter Kirk of Accenture explains

Mortgage lenders are entering 2009 focusing on two priorities. The first is to make their mortgage operation sufficiently lean and efficient for the current times. The second is to ensure it is flexible enough to be ready for strongly rising demand once confidence returns to the mortgage market - as it inevitably will. 

These twin focus areas involve balancing the short-term cost cutting required in the current low-volume environment with the need to sustain and grow the strength of the business for the longer term. Getting this balance right is made all the more challenging by the fact that the recent M&A activity means smaller players now find themselves competing with much larger combined competitors.

Changing dynamics

However, there are opportunities for lenders within these changing dynamics. The eventual rebound in the market is a question of when, not if - and those players who successfully negotiate the tough times and implement the right actions now will be well-placed to capitalise on the rebound, whenever it happens. The first step towards assessing and ultimately seizing these opportunities is to understand the impact of recent events on the dynamics and structure of UK consumer lending. In Accenture’s view, recent events revealed substantial weakness in the existing model and its supporting assumptions.

The interlinked debt hierarchy, or "credit pyramid", that has driven the UK consumer lending market in recent years is depicted in Figure 1. It consists of three layers of consumer debt - revolving credit (such as overdrafts and credit cards) at the top; unsecured loans in the middle; and secured credit (such as mortgages) at the bottom.

Throughout that time, money has steadily moved down through the pyramid. To manage their debt exposure and repayments during periods of readily-available credit and rising house prices, consumers and banks have tended to migrate debt out of revolving credit into unsecured loans, and then ultimately into secured debt. As well as transferring debt downwards to lower tiers within this hierarchy, consumers and banks can also transfer debt internally within a tier to other lenders offering preferential terms and lower rates.

The model falters…

With the onset of the credit crunch, this pyramid - and consumers’ latitude to move in a managed way between the three forms of debt - has effectively become deadlocked (see Figure 2). With borrowing severely constrained at the lower levels of the pyramid, and debt becoming more expensive throughout, consumers have found themselves trapped at each level, facing stark decisions about how to manage the intensifying pressures on their wallets. The consequences for lenders include rising levels of impairment and difficulties in trying to move customers on to other providers.

This gridlock reflects a disconnect between the way consumers and lenders perceive the workings of the pyramid. Retail borrowers regard moving from revolving to secured credit as a coherent progression towards lower risk and repayments. But many providers still regard the three levels as separate product sets, and do little to manage their customers’ movement between them. This is despite the fact that lower down the pyramid, both security and the level of debt (and therefore the lenders’ income streams) tend to rise.

…creating new opportunities for lenders

The current freeze in the credit pyramid is creating pain on all sides. However, it also creates opportunities for lenders - not least by providing a breathing space of lower lending volumes, in which lenders can address underlying issues in the quality of their book, the efficiency of their operations, and their level of customer service. They can then use these improved capabilities to kick-start the consumer lending pyramid once again, and to manage it more actively to build differentiation and loyalty among customers. Those organisations who do this successfully will be able capitalise more fully on the opportunities opened up by returning market confidence and volumes. 

In Accenture’s view, the mortgage lenders that will win out and deliver high performance in the reviving mortgage market will be those that make the right responses to the reduction in lending volumes and the seizing-up of the credit pyramid. This will mean focusing their investment on three key areas:

1. Focus on credit risk and pricing

To succeed in the post-crunch marketplace, and maximise their use of available credit, mortgage lenders will need to create capabilities that enable them to identify customers and their behavioural traits more clearly across all product lines which combine to make up the credit pyramid. This will enable joined-up, risk aware decision making all the way from customer acquisition to arrears which is based on a customer's total debt and risk profile. Ultimately this will allow lenders to confidently dip their toes in the mid and sub prime customer segments again and price accordingly.

Currently, many mortgage lenders are focusing on profitability rather than volume, and are only willing to lend to the highest-quality customers. Others have chosen to buy market share during the current lull in competitive pressures, and are still active - albeit selectively - in the mid-prime segment. Both approaches carry drawbacks, since the first means missing out on the much larger volume available in mid-prime, while the second raises the risk of taking on poorer-quality debt mixed in among the better-quality mid-prime opportunities. However, as liquidity in the global money markets improves there will be an inevitable return to lenders seeking additional customer segments from which to generate profitable revenues. A bank that transforms its credit risk data, insight and decision-making can screen out poorer-quality risk in mid-prime and build deeper, more profitable relationships with the lower-risk mid-prime customers as well as with higher-quality customers.

For lenders to achieve this win-win, they must apply the kind of sophisticated credit analytics more often found in credit card operations  -  a capability that enables lenders to differentiate between good and bad lending opportunities and price loans according to risk. Ultimately, rather than minimising lending or spreading the impairment risk across a wide customer base, a loan provider can seize the opportunity to become the sole lender to each customer throughout all levels of the pyramid, thereby building deeper, more profitable and more durable customer relationships.

2. Focus on simplification, automation and streamlining of operations

Accenture believes that a second characteristic of the mortgage industry’s future leaders is that they will use the current protracted slump in volumes as an opportunity to reshape and optimise their operations, in order to maximise profitability when volumes return. This will involve simplifying and automating processes throughout the mortgage value chain: streamlining the entire business for greater efficiency, effectiveness and agility.

This simplification will involve several coordinated steps in each area of the business. In originations processing, it will result in further automation of activities including underwriting, the collection of lending policy-related data - where document imaging at the point of sale will reduce back-office processing - and solicitor processing. And in post-completion servicing, customers will be able to complete simple servicing transactions, ranging from changing a payment date to applying for a pre-approved further advance, via secure internet servicing without contacting the lender.

For many, this process simplification will also precipitate a consolidation of mortgage books and their technology platforms. This in turn will enable consolidation of the central function teams that have been built up to manage diverse and complex back book processes. The net result will be more efficient processing operations supported by robust technology that can be expanded to support increased volumes at minimal additional cost.

3. Focus on customers

Delivering on the first two areas above will allow the post-crunch leaders to create unique customer experiences and relationships that rival the historic branch-based, face-to-face approaches of 20 years ago. By taking a holistic approach to each customer’s lending requirements, and integrating their lending and advice across the three levels of revolving, unsecured and secured debt, banks will be able to build deeper and more valuable relationships, reduce churn and boost cross-selling.

Implementing automated end-to-end customer-centric processes, taking risk decisions based on customers’ propensities, and creating additional flexible and customisable product bundles, will create an experience that customers choose to replicate - even if it costs them a few basis points on the interest rate. This will bring with it a richer seam of customer advocacy and cross-selling opportunities to be mined when the upturn comes.

The bottom line: becoming customer-centric

As mortgage lenders wrestle with the immediate impacts of the credit crunch, Accenture believes they should not lose sight of a key attribute of the current mortgage market: a significant one-off opportunity to transform the strength and durability of their relationships with customers.

To differentiate and achieve profitable growth in the post credit-crunch environment, mortgage lenders need to consolidate and rebalance each customer’s credit on his or her own terms, proactively helping the consumer navigate their own credit pyramid through the current tough times. They should also invest now in simplification and automation to create the basis for future competitive advantage. Those that take these steps in today’s stormy environment will be the industry’s long-term winners when the climate improves.

Peter Kirk is a senior executive at Accenture's retail banking practice. Accenture is a global management consulting, technology services and outsourcing company. www.Accenture.com