Data to diversification: 7 things digital lenders must do to manage risks

Assessing is challenging for digital lenders as they have to rely on alternative data sources and algorithms to evaluate creditworthiness

Every adversity brings with it the seed of an equivalent advantage, said Napoleon Hill in his bestselling book Think and Grow Rich. Covid-19 proved him right. As part of efforts to boost financial inclusion and credit penetration, India’s government seized an opportunity amid the pandemic to push digital lending. With the proliferation of smartphones and Wi-Fi offering tailwind, credit growth zoomed. Such growth touched a decadal high of 15.9 per cent in FY23 at Rs 148 trillion, according to our ratings division’s estimates.
 

The push for financial inclusion and the rise of e-commerce and digital payments have created new opportunities for digital lenders, who are leveraging technology to disburse loans to a wider audience. Data analytics, machine learning and artificial intelligence are used to assess creditworthiness, reduce fraud and offer personalised products to customers. This has made credit accessible and affordable for individuals and businesses.
 

The government’s stimulus for micro, small and medium enterprises (MSMEs) – through the credit-linked capital subsidy scheme for technology upgrade, credit guarantee scheme and purchase and preference policy – has renewed the focus on lending to small businesses. This, in turn, has helped digital lenders who have historically faced challenges in accessing credit from traditional banking channels.
 

Digital lenders offer loans to small businesses at competitive rates and with flexible repayment terms. They use alternative data sources, such as goods and services tax returns, Income-Tax returns and bank statements, to assess creditworthiness. Credit growth momentum is seen across segments since 2020 with agriculture growth at 8 per cent, MSMEs at 14 per cent, retail at 15 per cent and corporate at five per cent, according to estimates by the Reserve Bank of India (RBI) and our ratings division.
 

While digital lending has benefits, it has also raised concerns about related credit and systemic risks. To address these concerns, the RBI approved the first-loss default guarantee framework in June 2023. Assessing credit risk is crucial for digital lenders as it shapes their financial health, stability and the ability to partner with banks and non-banks. To effectively manage credit risk, organisations need to implement a robust risk management system that takes into consideration factors such as the financial stability of customers, market conditions and macroeconomic trends.
 

However, assessing credit risk can be challenging in the digital lending space. Unlike traditional lending methods, where lenders have face-to-face interactions with borrowers, digital lenders have to rely on alternative data sources and algorithms to evaluate creditworthiness – a space that is evolving. Another challenge is the lack of standardisation in data and processes. Digital lenders may have different criteria for evaluating credit risk, leading to inconsistencies in risk assessment and potentially higher defaults. Seven steps can reduce such risks for digital lenders:
 

•  Invest in advanced data analytics tools and leverage statistically tested algorithms to strengthen credit risk assessment
   
•  Implement policies such as setting credit risk appetites and establishing credit risk limits
   
•  Strengthen underwriting thorough credit checks and income verification
   
•  Diversify loan portfolios across industries, sectors and geographies to reduce the impact of economic downturns
   
•  Collaborate with banks to share data, risk assessment methods and best practices. This will help build trust between the two parties
   
•  Build a strong collection ecosystem to ensure a quality portfolio
   
•  Use data and analytics to personalise borrowers’ experiences. This can include tailored loan offers, customised repayment plans, relevant financial education resources and a reliable feedback mechanism.
   

To conclude, the need for risk assessment and management cannot be overstated in an evolving digital environment. Digital lenders need to implement the right risk management strategies to reduce defaults, improve credit quality and enhance customer experience.

The writer is president and business head, CRISIL Market Intelligence and Analytics