Credit Underwriting: How a Lending Decision Is Made

Credit underwriting is the decision a lender takes about whether to lend, how much, at what price and on what terms, using money it has mostly borrowed and owes back on a date of its own. The decision produces a price for a range of outcomes rather than a verdict on a person, and that price must cover the money, the work and the loans that do not come back.

A word first about the empty cells further down. Nine separate conditions a lender must satisfy turn up below, and each one arrives with its value missing and an address standing where the value would be. Each of the nine is decided by an authority that revises it, and a revision does not travel out and correct the records that copied the old figure. Each row therefore carries the question and the door to knock on, and the answer is fetched on the morning the answer matters.

Whose money is on the table before anybody reads an application?

Start on the wrong side of the balance sheet, and start there deliberately. Almost every explanation of lending opens with the borrower, and by the time it reaches the lender's own position the reader has already formed the picture that a lender is somebody with a pile of money deciding who deserves it. The picture of a lender with a pile of money to hand out makes the rest of the subject impossible to follow.

Rukmini Finance Limited, an invented lender, lends and takes no deposits. The lender carries assets under managementThe book of loans a lender is carrying at a given moment, measured in rupees. Because every ratio is struck on it, it gets named every single time. of Rs 18,000 crore. Behind that book sit Rs 14,400 crore of borrowings raised in the market and Rs 3,600 crore of its own net worthThe lender's own money. The amount left over for the owners of the business if every rupee it owes were repaid, and nothing more mysterious than that.. Divide Rs 14,400 crore by Rs 18,000 crore and 80.0 per cent of the book was funded with money that belongs to somebody else, on terms somebody else wrote.

The consequence is the whole reason to start here: the money the lender lends has a repayment date of its own, and that date does not move because a borrower's month was hard. Think of a stall outside a single office building that buys its stock on thirty day terms from a wholesaler. The wholesaler's thirty days were not negotiated with the customer in mind. However reasonable a request for ninety days from a regular customer might be, the stall cannot grant it and stay open. The liability came first and it decides the business.

Owing money back on a fixed date is the position every lending decision below is taken from. Rukmini Finance is not choosing who deserves money. The lender is deciding what to do with money it has already promised to return, at a price that has to be enough to return it.

What is underwriting actually producing?

State it flatly before anything is added. Underwriting is a decision taken now about money that comes back later, on information that is incomplete by construction, using funds that belong to somebody else. Every difficulty in the subject falls out of those three clauses, and no amount of technology removes any of them.

The decision produces a price for a range of outcomes, not a verdict on a person. When Rukmini Finance approves a loan at 14.50 per cent a year on the amount lent, it is not saying that this money will come back. The lender is saying that at that price, across everybody it lends to on those terms, enough comes back to pay for the borrowing, pay for the work, absorb the part that does not return, and leave something over. The rate is a statement about a spread of outcomes the lender expects to meet many times, and it is meaningless applied to one.

A price for a range of outcomes is the claim everything below defends. A great deal of loose talk about lending, some of it from inside lenders, treats an approval as a character reference and a decline as a judgement. An approval is neither. Approval and decline alike are arithmetic about a population, priced for a period.

What four things does every decision settle?

A lending decision is usually described as a yes or a no, and that description throws away most of it. Four separate questions get settled, and only the first one is the yes.

Look at what the middle two buy. A request that fails at one amount can succeed at a smaller one. A request that fails at one price can succeed at a higher one, if the price is allowed to move. Compress four decisions into one and the lender has not become stricter, it has become blunter, and blunt costs it business at both ends: it turns away lending it could have priced, and it takes on lending it has underpriced.

The fourth question is quieter and does more than it looks. The schedule decides when the lender finds out that something has changed. A loan repaid monthly reports on itself twelve times a year. The same amount repaid once at the end reports once, at the end, and the end is the last moment anybody can do anything about it. Whether the loan stands on any securityAn asset named in the loan agreement that the lender can look to if the money is not repaid. The assets that count as security, and the way security is taken, are settled separately. belongs to the same question.

Where does a lender's information come from, and on what permission?

Four routes, named by kind rather than by product. The first is what the borrower states. The second is what a credit information companyA company that collects repayment records from lenders and returns them, with a score, when a lender asks. The records it may hold, and the way an entry gets corrected, are taken up separately. holds and returns when it is asked. The third is what the borrower's own financial records show, where the borrower has agreed to share them. The fourth is what the lender already knows from an earlier loan it made itself.

None of the four routes opens on its own. Every route runs through a permission, and what a lender may collect, keep and share is decided by the Reserve Bank of India at rbi.org.in and moves. The requirement stands here and the condition attached to it is read at that address, on the day it matters, because a copied condition is wrong from the morning it changes.

The second thing worth fixing early is that a thin recordA borrower about whom little formal information exists, usually because they have not borrowed before. A thin record is a fact about the paperwork, not about the person. is an absence of information about a person, and not information about a person. Those are different objects and they behave differently. Absence of a repayment history means the lender does not know; it does not mean the lender knows something unfavourable. Treating the two as the same is the single most common way a lending process turns a gap in its own records into a conclusion about somebody, and it is a mistake in logic before it is anything else.

How is the price of a loan built up, and out of what?

Most readers picture pricing the wrong way round. The picture is that a lender decides on a rate, charges it, and whatever is left at the end is the margin. Work it that way and the rate looks arbitrary, and every question about why it is what it is dead ends. Build it upward from the funding instead and the rate stops being a choice and becomes a sum, with the margin as the last thing standing rather than the first thing decided.

Before the stack, one piece of arithmetic that surprises people. Rukmini Finance earns 14.50 per cent a year on assets under management and pays 8.50 per cent a year on borrowings, a spreadHow far apart the lending rate and the borrowing rate sit, in percentage points. A useful number, and a different one from the margin the book actually earns. of 6.00 percentage points. So the margin on the book is 6.00 per cent, surely. It is not. The margin is 7.70 per cent of assets under management, and the extra 1.70 points have a name.

Read it in two lines and it stops being a trick. Six per cent of Rs 18,000 crore is Rs 1,080 crore. Eight and a half per cent of Rs 3,600 crore is Rs 306 crore. The two amounts add to Rs 1,386 crore exactly, and that sum is the net interest incomeInterest earned less interest paid, over the same period. Net interest income is a rupee amount, and it turns into a rate only when it is divided by a base that has been named. for the year, and set against the Rs 18,000 crore of assets under management that reads 7.70 per cent. The lender's own money funds part of the book and pays no interest to anybody, and on these figures that is worth 1.70 points of margin on assets under management.

Now the stack. Four layers, all struck on the same base, all for the same year, built from the bottom.

Notice which base the first layer sits on. Rukmini Finance pays 8.50 per cent a year on borrowings, but borrowings are only Rs 14,400 crore of an Rs 18,000 crore book. The identical Rs 1,224 crore therefore reads 6.80 per cent against assets under management. Both figures are correct and they are answers to different questions. Neither may be written down without its base beside it in the same sentence.

The last row carries the whole of it. On a book of Rs 18,000 crore, what survives is 2.50 per cent, and 2.50 per cent is Rs 450 crore. A residual of 2.50 per cent is the honest scale of a lending business, and it is much thinner than the 14.50 per cent headline suggests. Thinness is also why the cost of fundsWhat a lender pays for the money it lends, stated as a rate for a period. On a book funded four fifths by borrowing it is the largest single item there is. is the first thing anybody who understands lending looks at, rather than the last.

Two things are worth taking away from moving that control. The first is that what is left before tax falls a long way for a change in funding cost that sounds modest. The residual is the thinnest layer in the stack, and it absorbs the whole of the movement. The second is quieter. Rs 3,600 crore of the book is funded by money that pays no interest at all, so the margin on the book moves by less than the funding rate does. Move the rate by 5.00 points across the whole range and the margin on assets under management moves by 4.00, which is exactly 80.0 per cent of it, the share of the book that is borrowed.

Credit Cost: what did the lending itself cost, and on what base?

Credit cost is the cost to a lender, over a stated period, of lending to borrowers whose money did not all come back. Credit cost is a line in the lender's own accounts. The charge is measured in rupees and reported as a rate only once a base is named.

Take the Rs 396 crore Rukmini Finance Limited charged for the year: set against the Rs 18,000 crore of assets under management it carries, that reads 2.20 per cent, and both the base and the period belong inside the sentence rather than in a note somebody may never reach. This is where the discipline of the whole reading starts, so it is worth seeing what happens when the base wanders.

Every one of those three divisions is arithmetically correct. Two of them are not the name of anything. A reader handed the figure 11.00 per cent with the word credit beside it and no base would have no way of telling which division produced it, and would carry away something between five and thirteen times wrong.

The second discipline on this figure is what it is not: Rs 396 crore is not a count of people and it says nothing about any of them. It is a rupee amount in one lender's accounts for one stated year. A rupee charge for a year carries no borrower detail, no count of loans, no rate at which repayments stopped arriving and no score of any kind, so a total of this kind can never be turned into a statement about a borrower. The total does set one bound. Rs 396 crore is the whole of the charge for the year, so no part of the book can have cost more than that, and the way the charge divides inside the book cannot be recovered from the total.

Provision Cost: what did the accounts recognise, and on whose clock?

Provision cost is the charge a lender puts through its profit and loss account in a period against lending the lender no longer expects to see repaid in full. Provision cost looks like the same thing as credit cost and it is not. The two get used interchangeably in conversation all the time, so keeping them apart is worth doing carefully.

Credit cost is what the lending turned out to cost; provision cost is what the accounts recognised in the period, and the two answer to different clocks. One is the outcome of lending. The other is a recognition event, and recognition follows a rule about the point at which an advance stops counting as performing and what has to be set aside once it does. The recognition rule is set by the Reserve Bank of India at rbi.org.in, and it moves.

A filled cell gets copied and a caution does not. The right panel therefore carries an address rather than a value. Taken apart criterion by criterion, the two make a comparison in its own right, and that comparison is covered separately. The one line above is what separates them.

Intermediated Distribution: who is party to the loan when somebody else found the borrower?

A great deal of lending now reaches the borrower through somebody who is not the lender. Another business ran the shopfront, took the application, or built a product with the loan sitting inside it so that the borrower met the loan while doing something else entirely.

Three things do not change, whoever ran the shopfront: the loan is the lender's asset, the money the borrower owes is owed to the lender, and the underwriting decision was the lender's. That is worth saying flatly because the arrangement is often described in a way that blurs all three, and a reader who is not clear about them cannot follow anything else in this part of the subject.

One thing does change, and it is not small: the lender now has a second party's conduct to answer for. How the borrower was approached, what the borrower was told about the cost of the loan, how repayment was pursued: all of it happened at arm's length from the lender and none of it stops being the lender's responsibility. The requirements on a lending service providerA business that brings a lender its borrowers, handles the paperwork afterwards, or pursues what is due, without the loan ever becoming its own. are set by the Reserve Bank of India at rbi.org.in, and they move.

The everyday version is a caterer who takes a wedding booking through an event agency. The agency found the client, agreed the date and quoted the menu. The food is still the caterer's food, the bill is still owed to the caterer, and if the agency promised a dish that was never on the list, it is the caterer standing in the hall on the night.

Distribution through a third party is one of the two big shifts in how lending reaches people. The other is what happened to the speed of the decision itself, and it is worth guessing at before reading it.

How Digital Lending Changes Credit Underwriting and Servicing: what moved, and what did not?

Three things changed and one did not, and the one that did not is the one worth the most attention.

Speed changed. A decision that took days is taken in minutes. Speed matters most to the person who needs the money this week rather than next month, and it is a real change rather than a marketing one. Sources changed. Records that a lender previously could not read at all can now be read, where the borrower has agreed to share them, and that widens the set of people about whom anything at all can be known. Servicing changed. Reminders, repayment and collection now run through a channel that reaches the borrower directly and constantly. A channel like that cuts both ways, and conduct in it is regulated for exactly that reason.

The arithmetic did not change, and it did not change even slightly. The stack is the same stack. The price still has to cover the funding, the work and the part that does not come back, and what is left is still a residual. A decision reached in ninety seconds using four sources instead of one is still a price for a range of outcomes, and the range did not narrow because the decision arrived sooner. Speed changes the experience of borrowing and the cost of running the process. Speed does not change what money costs or what a book of loans returns.

Two smaller things are worth naming. Faster disbursalThe moment the money actually leaves the lender and reaches the borrower. The steps between the application and that moment are set out separately. means the lender's own funding has to be ready sooner, which is a funding-side problem rather than an underwriting one. And a servicing channel that reaches a borrower constantly is a channel that can be used badly. The conduct required of anybody recovering what is owed is set by the Reserve Bank of India at rbi.org.in.

What can underwriting not do, however good it is?

Three limits, and none of them yields to better information or better technique.

Underwriting cannot see a future event. Nobody's income, health or employment is knowable a year ahead, and the output is therefore a price across a range rather than a forecast for one loan. Underwriting cannot see what it was never shown. An absence in a record stays an absence, and reading it as a finding is a logical error rather than a conservative choice. And it never learns what would have happened to the loans it declined.

Sit with the third one. The third limit is the strangest fact in lending, and it is rarely said out loud. Every lender has a complete record of what happened to the loans it made and no record at all of what would have happened to the ones it refused. The evidence arrives from one side only. A decline is therefore a decision taken under a permanent absence of feedback, not a judgement that was later confirmed. A rule that is quietly turning away people who would have repaid produces exactly the same clean-looking numbers as a rule that is working, and no amount of staring at the approved book will separate them.

Who sets the conditions a lender works under?

Nine of them turn up in this guide, and the table below collects them in one place rather than leaving them scattered through the reading. Every row carries the party that decides it and the address at which it is read. Not one row carries a value.

How does anyone actually use this?