Is this the end of the credit score? It’s certainly been predicted many times over the years, and the idea is back at the forefront after several big banks including JPMorgan Chase, Wells Fargo and U.S. Bank announced this month a plan to offer credit card products to those who lack a traditional credit score.
As first reported in the Wall Street Journal, the plan “is aimed at individuals who don’t have credit scores but who are financially responsible. The banks would consider applicants’ account balances over time and their overdraft histories.”
There are several reasons offered for moving away from traditional credit scores. They include helping to bring the unbanked into the financial system, extending credit to younger consumers who have not yet built up a history, and reaching undocumented immigrants. The big banks’ plan includes working with Equifax, Experian and TransUnion on data sharing as well as with fintech data sharing firms such as Plaid.
Reforming credit scores is also a policy goal of President Joe Biden, who has talked about creating a public entity that would “determine credit scores in a more accurate and less discriminatory way,” Reuters notes.
Loan Growth Opportunity:
Banks, credit unions and other lenders are looking at creative ways to get credit products into the hands of more consumers.
Where Do We Go From Here?
These tailwinds would seem to suggest the traditional method of credit scoring is on its last legs, but that may not be entirely true. For one thing, this latest proposal is merely a pilot program being used by a handful of banks for a small slice of their customer base.
Thousands of smaller banks and credit unions — as well as other lenders that don’t have the internal resources to create their own bespoke scoring system — still rely on credit scores to judge the likelihood applicants will repay loans, as well as to determine interest rates.
But many argue there should be some changes to the way credit reporting agencies determine scores. For example, banks, credit unions and other lenders were in a conundrum during the Covid-19 pandemic and couldn’t tell who was creditworthy using traditional scoring because of a provision in the government’s coronavirus stimulus package. The rule states that lenders who allow borrowers to defer their debt payments can’t report these payments as late to credit-reporting companies.
The issue was exacerbated as millions of people received stimulus checks or higher unemployment payments that allowed them to meet immediate financial obligations, but had no bearing on future financial stability.
That’s why some have argued for a system that more accurately measures cash flow. Jason Gross, CEO of fintech company Petal, says in a blog that cash flow analysis can offer lenders real-time insights that credit scoring alone can’t deliver.
Will This Work?
Proponents of ‘cash flow scoring’ say it could greatly increase the lendable universe.
“Cash flow scoring is simply an analysis of creditworthiness based on a consumer’s recent banking history,” says Gross. “It measures economic fundamentals that don’t show up in traditional credit reports, like people’s income and employment status, the bills they pay each month, and the amount they’re saving. Cash flow data also reflects sudden changes in income, whether it’s the stoppage of paychecks or the receipt of stimulus payments or unemployment checks.”
Equifax also touts cash flow analysis as a way to help deliver lending products to consumers without credit scores. It cites its “Cashflow Insights” service, which lets individuals share their online bank account information, including balances, deposits and withdrawals from more than 7,700 participating U.S. financial institutions.
Having such bank transaction data for all consumers could reduce the “credit unscorable” population by as much as half, Equifax predicts. “We believe use of bank transaction data alone — without other alternative data assets — could increase prime or better consumers by nearly five million people, says Equifax. “These numbers clearly show the impact that consumer-permissioned bank transaction data can have in providing a clearer picture of applicants.”
Nevertheless, Peter Wannemacher, a principal analyst with Forrester, says it is unlikely the traditional credit score is going away entirely, at least “for the foreseeable future.” The analyst adds that while there can be flaws in the way credit scores are calculated, “there is a lot that can be improved upon without having to fundamentally rethink the entire role they play.”
Wannemacher does believe it is likely that additional data that is closely related to financial health will be tapped to supplement credit scores on a more frequent basis if it helps makes for more accurate predictive decisioning.
Alternative Data Pros and Cons
The big three credit scoring agencies have publicly touted the idea of using alternative data as a way create credit scores for those who have little to no credit history. However, some say how this data is used must be closely monitored.
“Collecting increasing amounts of alternative credit data — especially data about short-term loans and utility payments — could lead to more adverse outcomes for some, especially in disadvantaged communities,” Fast Company notes. In fact, using alternative data could end up replicating “the same legacy of discrimination that’s already baked into a lot of the socioeconomic structures in our society.”
Not so Fast:
Efforts to use alternative data to improve credit scoring are coming under regulatory scrutiny.
To minimize the risk of discrimination and unfair outcomes, “more transparency is needed from the credit scorers,” says The Center for Financial Inclusion. Furthermore, without ensuring data integrity, it’s not realistic to expect alternative data to miraculously expand access to credit. In the absence of sound and uniform regulations on data privacy and laws on the fair use of alternative data, consumer protection risks outweigh benefits.”
Five federal agencies issued a joint statement on the topic in late 2019. They concluded that using alternative data can improve the speed and accuracy of credit decisions but lenders need to incorporate “a well-designed compliance management program that provides for a thorough analysis of relevant consumer protection laws and regulations to ensure firms understand the opportunities, risks and compliance requirements,” and work with regulators closely while implementing policies.
More Than Scores Must Change
The fact is, credit scores are so ingrained in how lenders make decisions that any movements away from them will most likely be incremental for the time being. Forrester’s Wannemacher believes it is more likely that how the industry views credit itself will eventually evolve.
“An alternative to the credit score needs to be not just a little better, but markedly better,” he says. “Will it ever happen? I think things will change not because someone came up with a better way to measure creditworthiness, but because the way the industry views creditworthiness has changed.”