Abstract
The profitability lending model was initially discussed by Eisenbeis [1] who suggested that it might be possible to build a lending model that prevailed the traditional scorecard models. In this paper, we study a unique dataset from a personal loan company based in the United Kingdom, which offered overdraft-style short-term loans to individuals with low and high credit scores during the last few years. Our results conclude that credit score does not significantly impact profitability in the overdraft market. Moreover, we argue that, assuming a good understanding of low credit score individuals, a business model that grants loans to these “new” customers is as sustainable and commercially viable as lending to higher credit profile applicants.
Highlights
An overdraft allows customers to borrow money through their Personal Current Account (PCA)
We study a unique dataset from a personal loan company based in the United Kingdom, which offered overdraft-style short-term loans to individuals with low and high credit scores during the last few years
This paper studies the effects of the application of a profitability model as an alternative to the credit scoring one in the UK
Summary
An overdraft allows customers to borrow money through their Personal Current Account (PCA). This view is supported by additional research [4] suggesting that nearly two-thirds of mortgage applications are rejected if a customer’s credit file includes just one payday loan. The results highlight the self-fulfilling and self-reinforcing nature of the reputation mechanism It is self-fulfilling because taking a non-standard lender high-cost credit lowers the credit rating of a borrower, which leads to more default, which justifies the decline in the credit score in the first place. Bell-curves in Figure 1 highlight the link between the UK’s average Experian credit score (650) and the incumbent banks arranged overdraft limits. Thanks to a unique dataset of personal loans granted to both low and high credit score individuals, we assess to what extent the determinants and the predictability of the two groups differ from one another and if the profitability of a business model that grants loans to low credit score individuals is economically viable
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