The Kenya Bankers’ Association Ag. CEO Raimond Molenje last week indicated that the Central Bank of Kenya (CBK) has approved all the applications lodged by banks regarding the roll-out of risk-based lending in Kenya’s financial services sector. This approval by the regulator marks a significant milestone for the country’s financial sector.

Financial service providers can now price loans based on an individual borrower’s risk profile, determined by the likelihood of default. This shift holds the potential to enhance financial inclusion by offering a wider range of borrowing options, especially to individuals who were previously locked out of traditional lending models. However, the adoption of this model presents various risks and complexities for financial institutions that must be carefully managed.

The promise of financial inclusion

Risk-based lending offers a compelling pathway to broaden financial inclusion in the country, where access to affordable credit has continued to be uneven. Traditional credit models relied heavily on fixed interest rates, resulting in a one-size-fits-all approach. This structure has often penalised lower-income individuals who might not have an extensive credit history or formal employment records. On the contrary, the risk-based lending model embodies the assessment of individual risk levels, allowing financial institutions to tailor loan offerings to different segments. Consequently, this makes it easier for micro, small, and medium enterprises (MSMEs) and individuals in the informal sector to access credit.

In a strict sense, borrowers with lower risk profiles could enjoy lower interest rates, while those with higher risk profiles would still be able to access loans, albeit at higher interest rates. This flexibility not only encourages borrowing but also supports the broader financial inclusion agenda, which is a key pillar of Kenya’s Vision 2030 and the CBK’s regulatory framework.

Risks of over-penalising high-risk borrowers

While the model presents opportunities, it comes with significant risks, particularly for high-risk borrowers. By linking interest rates to a borrower’s creditworthiness, there is the potential for interest rates to skyrocket for those deemed high-risk. This could push vulnerable groups into a cycle of debt or further exclude them from formal credit markets. If poorly managed, risk-based lending could deepen existing inequalities in access to finance, creating a two-tiered system where wealthier individuals benefit from affordable credit while lower-income groups are marginalised.

To avoid these pitfalls, financial service providers need to ensure that their risk assessment mechanisms are robust, transparent, and fair. The use of advanced data analytics, credit scoring systems, and even alternative data sources, such as mobile money transactions, can help financial service providers assess creditworthiness more accurately. However, financial institutions must be wary of unintended biases in their data models, which could unfairly penalise certain demographics or geographical areas. Financial service providers need to balance precision in risk assessment with inclusivity in their lending practices.

Regulatory oversight and consumer protection

The CBK has the crucial role of ensuring that the risk-based lending model does not lead to exploitative practices. Stringent regulatory oversight will be necessary to monitor how financial institutions price risk and ensure that they do not engage in predatory lending. For instance, the CBK could introduce caps on interest rate spreads to prevent financial service providers from charging excessively high rates to borrowers perceived as high-risk. Additionally, clear guidelines on the use of alternative data in risk assessment should be established to protect consumer privacy and ensure that data usage complies with Kenya’s data protection laws.

Furthermore, the CBK’s role in promoting financial literacy will be critical. Borrowers need to fully understand the implications of risk-based pricing, including how their behaviour affects their credit score and loan pricing. Financial institutions, in partnership with the CBK, should invest in consumer education programmes to ensure that borrowers make informed decisions and are aware of their rights under the new lending regime.

Balancing profitability with social responsibility

Financial service providers’ shift to risk-based lending presents a delicate balancing act between profitability and social responsibility. On the one hand, they need to manage their risk exposure and ensure that lending remains profitable. On the other hand, they must avoid being seen as contributing to financial exclusion by imposing prohibitively high interest rates on high-risk borrowers.

To strike this balance, financial institutions could potentially explore tiered interest rate models that allow for a gradual increase in rates rather than sharp spikes for high-risk borrowers. Additionally, offering products such as microloans or loans with flexible repayment schedules could provide high-risk borrowers with manageable pathways to build creditworthiness over time. Partnerships with microfinance institutions and fintech companies could also help financial service providers reach underserved populations more effectively, spreading risk while promoting inclusion.

The role of technology in risk assessment

The successful implementation of risk-based lending will depend heavily on how well financial service providers can leverage technology to assess and manage credit risk. With advancements in machine learning, artificial intelligence (AI), and big data analytics, financial institutions have access to sophisticated tools that can improve the accuracy of their risk assessments. These technologies can analyse a wide range of variables, from spending patterns to social media activity, to build a more comprehensive picture of a borrower’s financial health.

However, the use of these technologies must be accompanied by strong data governance frameworks to ensure that financial service providers remain compliant with data privacy laws and that their algorithms do not inadvertently reinforce social biases. Additionally, as the financial sector becomes more digitised, cyber risks will increase, making it essential for financial service providers to invest in cybersecurity measures to protect sensitive customer information.

Addressing default risk through credit insurance

Another way that financial service providers can mitigate the risks associated with lending to high-risk borrowers is through credit insurance. By offering borrowers the option to purchase credit insurance, financial institutions can transfer some of the risk of default to an insurer. This would allow financial service providers to lend more confidently to individuals or businesses with higher risk profiles, knowing that they are protected against potential losses. Credit insurance could also incentivise more responsible borrowing and repayment behaviour, as insured borrowers may feel a greater sense of security in taking on debt.

Policy recommendations for sustainable implementation

For the risk-based lending model to be sustainable, a multi-stakeholder approach is necessary. First, the CBK must work closely with financial institutions to develop a regulatory framework that encourages responsible lending practices without stifling innovation. This could include setting limits on the interest rate differential between low- and high-risk borrowers and ensuring that financial service providers offer flexible loan products that cater to different segments of the population.

Second, the government could consider establishing a guarantee fund to back loans to high-risk borrowers, particularly MSMEs and individuals in the informal sector. This would reduce the risk for financial service providers, enabling them to lend more freely to underserved groups without compromising their balance sheets.

Finally, financial institutions should adopt an inclusive approach to credit risk assessment. By incorporating non-traditional data sources and engaging with fintech partners, financial service providers can build a more nuanced understanding of borrower behaviour and creditworthiness, which can lead to more equitable lending practices.

 Conclusion

The approval of the risk-based lending model by CBK presents both opportunities and challenges for financial institutions. While the model has the potential to deepen financial inclusion and provide a more flexible credit environment, it also introduces significant risks, particularly for vulnerable borrowers. By adopting fair and transparent risk assessment practices, leveraging technology responsibly, and working closely with regulators, financial service providers can find a balance that promotes both profitability and social responsibility. Achieving this balance will be crucial in ensuring that the benefits of risk-based lending are realised across all segments of the Kenyan population.