Understand the new rules of creditworthiness assessment

Banks need to improve their creditworthiness assessment when approving loans. New EU guidelines require banks to document borrowers’ recurring income and expenses. Here is what you need to know.

Similar to PSD2 and open banking, the new EU creditworthiness legislation also lacks a definite guide to follow. It is more of a framework where financial players are going to fill out the blanks. And the blanks can be different from country to country. The review of the Consumer Credit Directive has come into effect after the second quarter of 2021, but financial players are still looking at each other to see what everyone else has done in search for an answer.

Outdated practices

The creditworthiness assessment process has so far primarily been relying on the users providing the data for the credit scoring. So, whenever someone needed a loan, banks presented them with a form asking questions about annual income, monthly expenses, and more. The review of the Consumer Credit Directive has questioned the correctness of the information provided by the borrowers‘. This is because most of the time, banks had no real documentation verifying what the users were saying.

The reliability of the creditworthiness assessment process has also been questioned due to the notable growth in the European consumer loan market. The value of new loans issued in 2019 exceeded €750 billion after a 46% growth during the past 6 years, according to the European bank organisation Eurofinas. With general interest rates falling on mortgages and new players entering the consumer loan market with Buy Now Pay Later products, the risk profile on these types of loans has gone up. When the COVID-19 pandemic hit, households became more financially vulnerable, which further accelerated the number of riskier loans on the market, according to the European Commission.

We see more and more banks approaching us to help them document the creditworthiness of their users. A lot of them see an increase in the amount of non-performing loans. This is a severe problem that causes a substantial loss of revenue,” says Thomas Laursen, Chief Executive Officer at Subaio

Documentation demand

The new legislation focuses on the documentation of the creditworthiness assessment process. Now, banks and other lenders need to document how and why they have given out a specific loan. This documentation process is regulated by the EU, and the European Banking Authority published a set of guidelines for the industry to follow. These guidelines will need to be implemented in each country by the local legislators. For instance, in Denmark, the Danish Financial Supervisory Authority published the local guidelines earlier this year.

In practice, financial players must now be able to identify customers’ different sources of income while also identifying their recurring expenses. In addition, they must be able to categorise these expenses with several levels of granularity. Looking at the market players who are already working with this, it is more than likely that the categorisation of recurring expenses has to be broken down into higher-level categories such as:

  • Housing costs
  • Transportation costs
  • Credit expenses
  • Personal expenses

While these higher-level categories also need to have a lower second level. For example, the lower-level categories of housing costs would be: 

  • Home loans
  • Property taxes
  • Water
  • Heat
  • Electricity
  • Rent
  • Insurances

The requirement to deliver data assessment with such granularity presents a major challenge for banks. On the one hand, this can create more friction in the customer journey resulting in a decline in revenue. On the other hand, it can create increased manual work behind the scenes for the financial players to live up to the new documentation requirements. So, this is a challenge that needs to be solved quickly. Otherwise, local authorities will visit the financial players sooner than later.

Digital creditworthiness check

Facing the reality that they need to comply with the new rules, some banks are hiring new employees to handle the requirements of the creditworthiness legislation. In practice, this means that new employees are hired to manually go through financial transactions and categorise them according to the level of granularity required. This is a significant trouble for banks. Before the new guidelines, they could rely on the data provided by the users. Now, they have to validate the information themselves.

The EU legislation does not specify how financial players must comply with the new rules. However, many banks hope to find an automated solution that categorises financial transactions. The financial market is trending towards digitalisation, so automation is one of the keys to finding and documenting both recurring expenses and income. There are multiple solutions available that can aggregate financial data via PSD2 and open banking. Yet, very few are able to identify the recurring transactions and categorise them according to the new legislation. 

Subaio’s data model can identify the recurring payments, categorise them and document it all for the needed creditworthiness assessment. It is what we do. We are already helping numerous banks on this journey,” says Thomas Laursen, CEO at Subaio.

Overall, banks must realise that they need to act quickly. Not complying with the legislation or complying with the legislation by manually going through transactions is a waste of their resources. Partnering with a fintech to develop an automated solution could be the answer. 

Subaio has just announced a collaboration with the open banking platform Aiia to build a whitelabel solution that will facilitate the creditworthiness assessment process.