This is the first of a three-part series by Sarah Davies, Chief Data & Analytics Officer at Nova Credit, addressing some of the major challenges in our current credit system – and how we can fix them.
Evaluating financial identity has been a work in progress for decades. And the goal of the credit risk industry has been and will always be to enable fair access to credit to all.
However, as I reflect on my career journey as a credit risk professional in the U.S. consumer lending industry, building VantageScore, and now exploring credit risk analytics globally at Nova Credit, I’ve come to realize one thing:
The modern consumer credit system is broken
I understand this deeply because I’ve helped contribute and reinforce the system. But there is a light at the end of the tunnel, and it involves a more inclusive way to lend.
We have the tools to build a fairer lending system to help a consumer achieve their own ‘American Dream’ – whether it’s buying their first house or getting the financial assistance they need to graduate college.
Just as there have been inflection points in the past with consumer credit expansion -- like FCRA, CFPB, receptivity to new data (cash/rent/telco) and analytic techniques such as machine learning that satisfy FCRA/ECOA criteria -- how lenders go about determining credit worthiness is once again reaching a pivotal point.
Admitting the problem: a broken credit system
Consumer credit reporting systems have all started with a framework to gauge consumer creditworthiness, one that involves the following:
- Businesses collect information on consumer financial behaviors with consumers as passive participants
- Information is shared among the businesses, making it widely available
- A credit rating system takes that information and makes it actionable
It’s not that this system hasn’t been successful at expanding access to credit. The first general purpose FICO score was released in 1989 and by 2007 they sold over 100 billion credit scores. Meanwhile, between July 2018 and July 2019, VantageScore sold 12.3 billion credit scores.
But the truth is the system has always been about the lenders and their ability to lend more to consumers – not the other way around. For all the progress the system has made, it’s brought about some pretty clear consequences for consumers – ones we’re still reckoning with today.
“The credit reporting system, in short, treats consumers primarily as its product, not as its customer.” - Consumer Reports, 2021
Our credit system is flawed. And we can already spot the symptoms, including unfair rejections to loans and credit cards, as well as inconsistent financial profiles among bureaus.
As for what’s leading to these symptoms – the answer boils down to risk assessment.
There are millions of high potential consumers, yet based on the current system their risk is simply unknown. That means they automatically get treated as high risk. Simply put, the hurdles in the system – the very specific types, volume, and timespan of one’s credit history – do not actually assess credit worthiness.
And that’s a shame, considering a lot of these consumers are younger in their lifecycle, giving lenders the opportunity to be the first in wallet. This could lead to tremendous loyalty and high CLTV, whether through higher education loans or buying their first homes.
The underlying problems with our credit reporting system haven’t gone away. What’s more, both consumers and lenders are dealing with the consequences:
Today, at least 60 million consumers are excluded from the system. Many of them don’t trust it – and with good reason: A 2021 study from Consumer Reports found that a third of consumers had errors in their reports. Plus, since consumers are passive participants in the current system, they have to retroactively work with bureaus to correct mistakes that impact their ability to get a loan – a less-than-fair arrangement.
The consequences for lenders are just as pronounced. Right now, lenders aren’t able to address the growing consumer base. That means they’re often turning to risky, quick-fix solutions like adding incremental ‘alternative’ datasets. And as a cherry on top, they need to then deal with the inconsistency in data reporting across sources.
We can and must collectively move and expand credit access. Given the place we find ourselves, this can only be at the speed of trust.
Why we’ve been sticking to a broken system
I know the mistakes and gaps of the modern consumer credit system, because I helped contribute to it and helped reinforce it.
Looking back at my experience in the U.S. consumer lending industry, I focused on the dataset that was popular and prevalent at the time. We capitalized on advancements in analytics based on credit data, introducing trended data, and making incremental improvements to modeling on credit data. But inherent to this data and the analytic methods were many of the same hurdles that we have always faced… a dependency on conventional loan products and consumer behaviors, and techniques that still required vast volumes of data in order to develop sufficient precision.
Why we’re stuck with what we have
The financial system had historically optimized for lenders to grow their portfolios. At that point in time, consumers had no choice but to take what they were given.
Now, it’s the consumer who’s in the driver’s seat with more access and control than ever before to data that can help their financial wellbeing. With BNPL as a payment alternative and data aggregators making it easier for consumers to access their data, the script is flipping.
The system has to change, and we can’t build an inclusive future through incremental means.
Resolution
To fix our mistakes, we need to embrace a new framework for credit risk scoring – one that is even more accurate, explicitly accessible to the consumer, allows the consumer to choose whether to participate and is fair for everyone -- and by fair, I mean open, transparent, and credible.
I believe that cash flow based underwriting is the answer. Changes in technology have enabled consumers to control their online data and how it’s used more than ever before, and we must embrace it. Examples of consumer control include GDPR, Web3, and open banking.
From a pure credit risk standpoint, the new system must achieve scalability, ability to predict risk, and ease of integration.
This is the story of growth, and when we invite the consumer to the table, we may finally be able to solve financial inclusion once and for all
We’ve always had the capacity to change, we just haven’t. This is how it starts.