Here is a brief excerpt from an article written by Tobias Baer for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.
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Lending institutions can significantly improve collections success by applying innovative treatments based on behavioral segmentation.
Lending institutions know that risk-based segmentation of their outstanding loans does not in itself help get their money back. At-risk customer segments, once identified, need to be approached with the most effective collections strategies. But lenders find that their approaches won’t work for some customers—often enough a lender cannot even get these customers on the phone, let alone convince them to repay their debt. Many, even those who owe money to more than one bank or business, should be able to pay at least a part of their debts. But this group is no more likely to pay than those who are not able to pay due to unemployment or other misfortunes. Clearly, new and innovative treatments are needed. The place to begin is behavioral segmentation, an analysis that uses psychological insights and advanced analytics to build a closer profile of customers within the same risk segment. Based on that profile, new and innovative treatments can be tailored that can improve success rates.
The approach applies a variety of techniques, as by definition, there is no one-size-fits-all solution. Some of the techniques are exclusively applicable to early-stage collections, while others may be more effective in mid- or late-stage efforts. In some situations, a particular technique may achieve full repayment; in others, the same technique will provide incremental improvement. However, the approach costs little to implement and can reap significant rewards. In select collections segments, leading banks using behavioral segmentation have demonstrated improvements of 20 to 30 percent in the amounts collected and the number of loans written off.
With the readily available data, banks can apply advanced analytics to group at-risk customers into categories that systematically reflect the customers’ subjective experiences and the reasons that they have failed to pay. Nonpayment has a range of causes and motivations, stretching across fuzzy boundaries from material hardship to behavioral dysfunction. Behavioral segmentation, while not an exhaustive framework, is a useful method for mapping subgroups within the larger at-risk segment according to their reasons for not paying.
A recent McKinsey survey of 420 US consumers with credit delinquencies shed light on the various causes of nonpayment. One prominent cause is difficulty in managing money through a monthly cycle. One-third of those surveyed expressed a preference for a weekly or semimonthly repayment schedule. Some respondents said that such rhythms would better conform to their pay days; many said they could better manage smaller, more frequent payments than monthly bills (smaller payments also hurt less). Motivations to pay also varied among respondents. Many overdue customers said that they wanted to maintain a good credit record and easy future access to credit. Others gave more values-based answers, such as a fundamental belief in keeping their commitments. By understanding motivations like these, lending institutions can better encourage payment from their at-risk customers.
Motivations can be particularly important when a customer owes money to several lenders. One-third of survey respondents prioritized payments rationally—for example, by tackling debts with the highest interest rate first or to secure another benefit, such as the retention of their most useful credit card. Payments by the remaining two-thirds followed less rational patterns. These respondents adopted a variety of approaches: they apportioned payments equally or by loyalty to a particular bank; some set up intrinsic milestones, such as paying off the largest or smallest balances first. By discovering particular motivations, banks can either reinforce them with tailored payment plans or help customers adjust their rationales (Exhibit 1).
A need for “agency”
The need to exert control or agency in one’s life is a recognized psychological need. To feel in control, many overdue customers refuse to speak to collectors (making effective use of caller ID). At the same time, they also intend to make a payment as soon as they have the money. To serve these customers most effectively, banks should have well-functioning self-service channels allowing partial payments to be made online or with a smartphone. Websites should be offered to permit late-stage delinquent customers to explore and commit to flexible payment plans.
Violating a customer’s need for agency can trigger counterproductive reactions, which psychologists call “reactance.” A customer might refuse to pay simply to assert control. In one survey, 20 percent of respondents said that they withheld a planned payment at least once after receiving an upsetting call from a collector. At the same time, 80 percent of respondents were not unduly disturbed by collections calls, yet clearly many of these would not have made payments without firm prodding.
Behavioral segmentation helps collections managers find the best approaches by customer profile and avoid fatally mismatched ones. Some historically high-risk customers, for example, need to be treated as late-stage delinquent when they are barely two weeks past due. Other customers are so low risk that they can be treated as “self-curing” and only given a gentle service call (a classic early-stage treatment) after several nonresponsive months. Many collectors nonetheless take a simplistic, stereotyped view of their customers—especially late-stage customers. Such ingoing biases can act as self-fulfilling assessments, as the collector’s (behaviorally mismatched) approach triggers an expected (uncooperative) response.
As these observations illustrate, collections strategies and actions will influence customers, positively or negatively, in their complex decisions on whom to pay and when. Customer decisions, like all decisions, are subject to bias and other psychological effects. A previous McKinsey piece, “The business logic in debiasing,” discussed the effect of biases on business decisions. Many of the same biases affect customers and some can keep them from paying. Banks that understand this dynamic can develop interventions to change it. The approach involves offering inducements to help customers resolve their financial troubles and pay down their debts. It is aligned with a growing field of research into irrational human behaviors that surround financial decisions. In October 2017 Richard Thaler, a behavioral economist at the University of Chicago, won the Nobel Prize for his contributions, which analyze the effects of human behavior on financial outcomes. Thaler popularized the term “nudge”—a benign and often small adjustment that counters irrational impulses.
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Here is a direct link to the complete article.
Tobias Baer is a partner in McKinsey’s Taipei office.