Automated decisioning is widely denoted in the credit industry as a way for many lenders to increase efficiencies, by increasing the volume of loans they write without increasing overheads, such as staff. Although this is a powerful contributing factor for any lender considering automation of current manual processes, a majority of lenders still don’t fully appreciate the complete benefits of switching to a more automated approach.
When working with our customers and prospects, the feedback I often receive from lenders is that their agents regularly deviate from their prescribed list of tasks/rules when underwriting a loan, especially in larger organisations where management cannot comprehensively monitor which loans are being funded and how they were underwritten. This is a common dilemma in many businesses and is referred to in microeconomics as the “Principal-Agent Problem”.
The Principal-Agent Problem, describes the relationship between an Agent (normally an employee) and the Principal (normally a Manager), where the Agent is under contract by the Principal to
“...perform some service on their behalf which involves delegating some decision making authority to the Agent.” 1
If both parties in the relationship are looking out for their best interest (also known as maximising one’s utility),
“...there is good reason to believe that the Agent will not always act in the best interests of the Principal. The Principal can limit divergence from their interest by establishing appropriate incentives for the Agent and by incurring monitoring costs designed to limit the aberrant activities of the Agent.” 1
As such the Principal must establish appropriate incentives as well as incurring monitoring costs so that the Agent’s interest aligns with the Principal’s. This is commonly referred to as Agency Cost and can be defined as the sum of;
- The monitoring expenditures by the Principal,
- Financial compensation such as bonuses,
- The residual loss, e.g. the reduction in revenue experienced by the Principal as a result of the Agent’s divergence.
Jensen and Meckling state that it is near impossible for the Agent to make optimal decisions from the Principals viewpoint. Therefore, the Agency Cost can be small but never zero.
In a lending situation, the underwriter’s (Agent’s) decision making may not always align with management’s (Principal’s) viewpoint. This can be down to a variety of reasons such as a lack of proper training, human error, new regulation or the simple fact that the Agent has different ideas to the Principal.
“Inevitability, different people make different decisions. These inconsistencies stem from the complex and mulitfaced task of tallying up all the factors that go into an underwriting decision-including assessing the voluminous material within the applicant’s credit files” 2
The result of these inconsistencies from the underwriter may impose a residual loss upon the lender, whereby the loan the Agent has funded enters default. Lenders can reduce these residual losses by increased monitoring or employee incentives, however, these still add an additional Agency Cost.
“Human underwriters cannot be expected to access 10 or more elements in a loan application accurately and consistently from application to applicant” 2
As such, decisioning platforms reduce a large proportion of this reliance and responsibility that lenders sometimes impose on their staff and therefore, Agency Costs become close to their optimal point. In some circumstances, lenders use automated deicisoning platforms to auto-decline and auto accept applicants with only a proportion of loan applications being sent to manual underwriting, where further tasks are undertaken by the underwriter to access whether the loan should be funded. As such, many lenders opt to use decisioning platforms to work with their staff and not against them.
The argument for automated underwriting vs manual underwriting will be one that I am sure will continue to drive debate in the credit industry, however, the main point of this post was to highlight the other relative benefits and cost savings of taking a much more automated approach, which I believe many lenders sometimes overlook.
- Theory of the firm: Managerial behaviour, agency costs and ownership structure, William H. Meckling and Michael C. Jensen, 1976
- The Promise of Automated Underwriting: Freddie Mac’s Loan Prospector, Peter E. Mahoney and Peter M. Zorn, 1997