Risk predictions for 2020: 2) Bolstered model risk practices
Risk predictions for 2020: 3) Optimisation will fuel a growth engine
11 February 2020
2020 will be the year of opportunity, efficiency and growth. That’s why price optimisation makes it into our top predictions for this year.
In the context of loan pricing, optimisation can be utilised to maximise the profit from loan applicants while satisfying business and regulatory constraints such as bad debt, loan take-up and headline rate regulatory requirements.
Using mathematical optimisation techniques, lenders can maximise profit from interest income. Recently, we saw a client’s profits double using this approach.
Lender’s profit margins continue to be squeezed as regulatory demands increase and the competition grows and gets smarter. Lenders must look at all options to increase margin and the most direct way of doing this is through the interest rate offered with the loan.
Many firms adopt a risk-based pricing approach, but the determination of the risk bands, and the optimal prices to offer in each band for the different loan products, requires sophisticated modelling of income and the impact of price on the consumers propensity to accept the offer.
The choice of price also needs to recognise wider market, business and regulatory requirements such as market position, headline rate compliance, sales and bad debt targets... and also capital supply. With this in mind, optimisation techniques are key to determining the prices that meet these constraints and maximises the yield from the loan book.
What should a lender do?
Optimisation is often disregarded due to the associated complexities, the dangers of incorrect models yielding undesired results, and perceived costs of implementation. Lenders should consider bespoke developments underpinned by leveraging existing models, with enhancements where necessary, combined with any new component models to complete the optimisation framework.
A bespoke approach offers significant cost savings compared to third party off-the-shelf products and provides the firm with transparency and control of the optimisation engine. Another key advantage with a bespoke approach is that firms can start simply and evolve their optimisation engine adding in sophistication after the early benefits are realised to ensure they continue long into the future.
What are the benefits of adopting it?
- Control and transparency of models
- Significant profitability increases (doubling in profits with some clients)
- Enhanced model components can be used elsewhere in the business
- The optimisation approach can be used to solve other business problems beyond pricing, such as limit setting or resourcing
What are the risks of not adopting it?
- Loss of business to competitors who can gain an edge by putting these sophisticated techniques in place themselves
Get in touch to find out more about price optimisation.