Limit Management is probably the most powerful profit driver that any lender, particularly a transactional lender can use. In this brief article, we explore why this is so and what principles should be engaged in order to maximise the potential of this incredibly powerful technique.
When a company lends money to a portfolio of customers, they always start from a position of low information. They do their best to assess the credit worthiness of the credit applicants but those applicants have never actually borrowed money from THIS particular lender before and as such there is always the big unknown: “Will they pay me back?” Because of this low information scenario, a lender is forced to be conservative both in deciding who to lend to and how much.
Six to twelve months later, the lender has considerably better knowledge of this portfolio. In the main, the early fraudsters, those who couldn’t figure out how to engage with the payment mechanisms and those who blatantly couldn’t afford it have now revealed themselves. A lender can easily identify a portion of their portfolio who are excellent risk on the basis that they have paid their dues every month since coming on-board. In this group lies enormous profit opportunity, as a lender knows that they can be far less conservative with them – offering them deliberate and generous increases to their credit limits.
A Practical Example
To understand how big an impact this could have, consider the following over-simplified scenario:
· A lender has a portfolio of 1,000 customers, all of whom have borrowed R10,000 (total loaned = R10 million)
· There are 100 “bad payers” amongst that base, who are not going to pay that money back
· The initial risk is 100 x R10,000 = R1 million that could be lost to bad debt. 10% of the total amount loaned.
· 6 months in, the lender could increase the limits of those 900 customers who are not bad payers to R20,000 each. Now the total outstanding is R10,000 x 100 + R20,000 x 900 = R19 million. So the bad debt as a percent of the portfolio is now only 5.6%
· On a profit level, if the lender earned 20% of the money owed, then
o in the first scenario they would earn
§ R10,000 x 900 (the good payers) x 20% = R1.8 million
§ Minus the R1 million bad debt loss
§ Profit R800,000
o in the second scenario they would earn
§ R20,000 x 900 x 20% = R3.6 million
§ Minus the R1 million bad debt loss
§ Profit R2.6 million
So in theory, in a very oversimplified scenario, using limit management could more than triple profits!
Unfortunately, there are many factors that will reduce that profit effect. It is important to use the right principles when engaging in limit management activities to maximise the profit advantage that one will achieve.
Principles to maximise profit advantage
1. Pair with marketing and response processes: The best risk clients often do not take up credit limit increase offers. As such, it is always best to pair offers with good marketing and response triggers to maximise response. Using modern principles such as response models, segmentation, etc. to drive the right message to the right person at the right time helps deal with this challenge
2. Have a strong re-application process: An increase in offer can put pressure on a customer’s affordability, thereby driving up their chance of default. It is important that the limit increase offers are paired with sound re-application processes and credit scoring models – ideally utilising external data as well as internal information. These will help ensure that increases are not given in such a way that they drive increases in bad debt that exceed the value gained from increased revenues
3. Test and Learn: Because there are so many levers and success/failure measures associated with this activity, it can be difficult to tell what the best mix of selection (who to increase) and action (how much to increase) is. Well-structured champion-challenger test and learn campaigns can help with discovering this, and also allow one to continuously learn what works better and what doesn’t work
4. Don’t just increase, also decrease: With good credit models, one can also identify the “maybe bad payers” on a portfolio. Those who have made some payments but also missed some. By the same logic (that increasing the exposure to the good payers increases revenues) reducing the exposure to the bad payers also improves profit (by reducing losses). Proactively reducing the limit exposure to those who are, for example, more than 2 payments behind will reduce the potential bad debt losses and therefore improve profits
5. Measure, Measure, Measure: Make sure you measure everything to do with your portfolio. Don’t focus your measurements only on one aspect (such as interest revenue) and neglect the counter aspects (such as bad debt). The optimal profit point lies in balancing the positive and negative factors which one can only do if you carefully and accurately measure all the key factors that impact on the portfolio profit equation
The above are a few examples of principles that can help one maximise the profit benefits achievable from limit management strategies. If you would like to discuss limit management strategy in more detail or would like to know more about the kind of systems that are capable of dealing with the fast pace of change, then please feel free to contact the Incline Group who can put you in touch with the right people.