Following the unprecedented economic shock caused by COVID-19, it was no surprise to see lenders increasing their loss reserves to brace for rising defaults. While both governments and lenders have taken steps to protect borrowers, the wave of economic disruption and unemployment will inevitably impact retail lending portfolios in the near term.
But what may not have been expected was the rapid recovery of volume that occurred once the dust began to settle. Despite industry-wide concern and initiatives to tighten credit standards, the auto lending industry has rebounded rapidly – US retail auto sales for September 2020 are up 3.4% over September 2019, with powerhouse Ally Financial recording their highest quarterly volume in five years.
This strong recovery is reassuring, but it does raise some questions. How confident are lenders that the borrowers of today will behave like the borrowers of the past? And how can lenders use pricing to navigate the turbulent economic climate safely?
Ensuring Profitability as Customers Change
As these record volumes pour in, it is critical that lenders stay ahead of emerging trends in both default risk as well as trade-in and prepayment behavior. Even prior to 2020, consumers were borrowing larger amounts over longer loan terms, with many trading in vehicles long before their loan was paid off. These trends are precarious even in the best of times, with many consumers borrowing for new vehicles while still underwater on their trade-ins.
Lenders must be certain that their pricing incorporates the most current behavioral modeling in order to capture these shifting trends – institutions managing to NPV must especially be able to identify which 72mo loans will be traded in after 18. And while the rates commanded in the prime and near-prime markets can lead to outsized NIM, modern and precise prepayment and risk modeling should also be incorporated into pricing calculations to understand the true value of each loan.
Pricing as Risk Management
I don’t think any bank left March 2020 feeling completely confident about their risk exposure. With whole industries decimated, many rock-solid borrowers turned into major credit risks overnight. Likewise, the payment deferral plans most lenders instituted (and some countries mandated), left lenders in the dark about which loans might eventually turn bad once payments resumed. With so much up in the air, banks all over the world increased their loss reserves significantly, with many also tightening their credit policies or taking other steps to decrease their exposure.
With significant upheaval in both the composition and risk profile of their portfolios, lenders must be able to rapidly adjust segment-level demand and revenue to match. While blunt instruments like credit thresholds are one approach, personalized pricing represents a more granular, focused approach.
For example, a pricing framework with integrated elasticity and risk models can be used to limit demand in longer-term loans or higher risk segments, while identifying those specific pockets of customers whose value outweighs their expected cost. And as the portfolio and credit policies continue to evolve, it is critical that pricing analytics and deployment are able to keep up. Given the rate of change and disruption in the market, time-consuming pricing deployment processes are no longer simply “inconvenient.”
As the shocks of 2020 continue to reverberate through global auto lending markets, it seems we are a long way from the kind of “normal” we had gotten used to. But with the right pricing strategy, empowered by smart analytics, lenders can navigate this upheaval with confidence. Those who are empowered with agile, AI-driven pricing can pivot quickly on risk without sacrificing sales or profitability.