Banks are playing with credit rating dumping due to lending decisions

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Is this the end of the credit rating? This has certainly been predicted many times over the years, and the idea is back in action after several major banks, including JPMorgan Chase, Wells Fargo and US Bank, announced this month a plan to offer credit card products to those who have who do not have a traditional credit rating.

As first reported in the Wall Street Journal, the plan “targets people who do not have a credit rating but who financially responsible… Banks will review applicants’ account balances over time and their overdraft history. ”

There are several reasons for ditching traditional credit ratings. These include helping to attract unbanked people into the financial system, providing loans to young consumers who have not yet gained experience, and reaching out to undocumented immigrants. The big banks plan to work with Equifax, Experian and TransUnion for data exchange, as well as with fintech data exchange companies such as Plaid.

Reforming credit ratings is also a political goal of President Joe Biden, who talked about creating a government organization that “would determine credit ratings in a more accurate and less discriminatory way,” notes Reuters.

Possibility of credit increase:

Banks, credit unions and other lenders are looking for creative ways to get credit products into the hands of more consumers.

Where do we go from here?

These tailwinds would seem to suggest that the traditional credit rating method is on its last legs, but this may not be entirely true. First, this latest offering is just a pilot program being used by several banks for a small fraction of their customer base.

Thousands of smaller banks and credit unions, as well as other lenders that do not have the internal resources to build their own personalized scoring system, continue to rely on credit scores to judge the likelihood that applicants will repay loans and to determine interest rates. … …

But many argue that some changes need to be made in the way credit reporting agencies determine their ratings. For example, banks, credit unions and other lenders were stranded during the Covid-19 pandemic and were unable to tell who was creditworthy using traditional scoring due to a position in the government’s coronavirus stimulus package. The rule states that lenders who allow borrowers to defer payments on debt cannot disclose those payments as late as possible to credit reporting companies.

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The problem was compounded as millions of people received incentive checks or higher unemployment benefits that allowed them to meet immediate financial obligations but had nothing to do with future financial stability.

This is why some are in favor of a system that measures cash flow more accurately. Jason Gross, CEO of fintech company Petal, says on a blog that cash flow analysis can offer lenders real-time information that credit scoring alone cannot provide.

Will this work?

Advocates of “cash flow scoring” say it can significantly increase the loan.

“A cash flow assessment is simply a credit analysis based on a customer’s recent banking history,” says Gross. “It measures economic fundamentals that are not reflected in traditional credit reports, such as people’s income and employment status, the bills they pay each month, and the amount they save. Cash flow data also reflects sudden changes in income, whether it is the termination of paychecks, receipt of incentive payments or unemployment checks. “

Equifax also touts cash flow analysis as a way to help consumers provide credit products without a credit rating. He cites his Cashflow Insights service, which allows individuals to share their bank account information online, including balances, deposits and withdrawals from over 7,700 participating US financial institutions.

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Having such banking transaction data available to all consumers can reduce “bad creditEquifax predicts the population will be half. “We believe that using only banking transaction data – without other alternative data assets – could increase the number of major or top consumers by nearly five million,” says Equifax. “These numbers clearly show the impact that consumer-authorized banking transaction data can have in providing a clearer picture of candidates.”

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Still, Forrester’s chief analyst Peter Wannemacher said it is unlikely that traditional credit ratings will disappear entirely, at least “for the foreseeable future.” The analyst adds that while there may be shortcomings in the way credit ratings are calculated, “there is a lot that could be improved without having to fundamentally rethink the entire role they play.”

Wannemacher believes that it is likely that additional data that is closely related to financial health will be used to replenish credit ratings more frequently, if this helps to make more accurate predictive decisions.

Alternative data pros and cons

The Big Three credit rating agencies have publicly touted the idea of ​​using alternative data as a way to create credit ratings for those with little or no credit history. However, some say that it is necessary to carefully monitor how this data is used.

“Collecting an increasing volume of alternative credit data – especially data on short-term loans and utility bills – could lead to worse results for some, especially in disadvantaged communities,” notes Fast Company. In fact, the use of alternative data can lead to the reproduction of “the same legacy of discrimination that is already ingrained in many of the socio-economic structures of our society.”

Not so fast:

Attempts to use alternative data to improve the credit rating are under scrutiny from regulators.

To minimize the risk of discrimination and unfair outcomes, “more transparency is required from credit agencies, ”says the Center for Financial Inclusion. Moreover, without ensuring data integrity, it is unrealistic to expect alternative data to miraculously increase access to credit. In the absence of strong and uniform data privacy regulations and laws on fair use of alternative data, the risks of consumer protection outweigh the benefits. ”

Five federal agencies issued joint statement on this topic at the end of 2019. They concluded that the use of alternative data can improve the speed and accuracy of lending decisions, but lenders need to include a “well-designed compliance management program that carefully reviews relevant consumer protection laws and regulations to ensure firms understand the opportunities, risks and regulatory requirements ”and work closely with regulators to implement the policy.

Read more:

More than grades must change

The fact is that credit ratings are so ingrained in the way lenders make decisions that any deviations from them are likely to be gradual for now. Forrester’s Vannemacher believes it is more likely that industry attitudes towards credit will eventually change.

“The alternative to a credit rating should not only be slightly better, but also noticeably better,” he says. “Will this ever happen? I think things will change not because someone has come up with a better way to measure creditworthiness, but because the industry’s attitude towards creditworthiness has changed. “

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