Inclusive credit scoring
28.02.2018
A known barrier to financial inclusion is the credit scoring approaches utilised by both mainstream and affordable lenders. Because of them, UK households could be paying £1,770 extra per year for basic everyday goods and services. For people on low incomes this premium is a significant opportunity cost to potential savings, among other things.
Credit Reference Agencies (CRAs) therefore play a critical role in including and excluding consumers. Despite this, they have not kept their models up to date with the diverse needs of modern financial life.
Existing credit scoring models create ‘invisibles’, ‘unscoreables’ and ‘thin file’ rated individuals if a consumer does not have a traditional financial background. They are based on lifestyles and payment flows from an era where people were employed in steady work with predictable income. Provision of credit files is dominated by a handful of companies globally, all using similar data sources and scoring models. Consequently, traditional credit scoring models lack the ability to accurately capture the creditworthiness of many consumers today, and as a result consumers are either completely excluded or pay a premium for credit.
For a fair and inclusive financial system to become a reality, CRAs must begin to take their responsibility for financial inclusion seriously, as the negative implications of exclusion on individuals and communities are far reaching.
These increasing concerns surrounding the current credit scoring methodology is driving the development of new approaches, including what has been termed ‘inclusive credit scoring’.
Responsible Finance and Centre for Business in Society (CBiS), Coventry University have been funded by Oak Foundation to undertake a research programme to advance the supply of sustainable and affordable finance to consumers excluded from mainstream credit. The full inclusive credit scoring research paper is one phase in the series and can be read here. The programme’s particular focus is to investigate how to overcome barriers to affordable lenders meeting consumer demand both at a national scale and sustainably.
Existing credit scoring models
Credit scoring is used within financial services to ensure appropriate lending, in line with business and organisational objectives. It is designed to check whether the consumer can meet any new payment obligations. When a person applies for credit, they complete an application which tells the lender lots of things about them. Each fact about the potential borrower is given points, which are added together and given a score. The higher the score, the more creditworthy a person is.
In the UK, CRAs compile information on how well a person manages credit and makes their payments based on previous history. For example, this can include information on credit card repayments, overdrafts, mobile phone contracts and utilities. This information is supplied to providers of credit and then factored into the lending decision. All CRAs hold similar information. For people who do not have a full and steady history of making payments, the credit score provided by the CRA may be poor or thin. This results in them being locked out of mainstream credit systems, or facing reduced choice, higher costs and possibly greater risk in accessing credit through alternative lending provision.
The issue is that this ‘locking out’ is increasingly shown to only be loosely related to the ability to pay for lending. In the UK, a survey of 2,000 consumers and found that 57% were at risk of being turned down for credit. This included a third who were in full time jobs and a third who earned more than £50,000 per year. The most affected simply didn’t have a credit history. Other reasons included not being on the electoral register or a homeowner, alongside more expected reasons such as missing payments or having too many cards.
New inclusive models
The search for new approaches in credit scoring is being advanced by existing CRAs and new entrants. These approaches are being driven by the development of ‘big data’, ‘digital infrastructure’ and the associated opportunities of disruptive new business models (fintech).
The new models are designed to address shortfalls in traditional credit scoring by assessing creditworthiness using different data sources, alternative forms of data, and wider sets of financial and non-financial analyses. The challenge for scoring models and the data that they are based on is to capture creditworthiness within the diversity of contemporary lifestyles. They do not aim to lower the bar for credit ratings.
New types of data that are being incorporated into models are:
Mainstream alternative data – data that closely resembles baseline credit data, obtained directly from the businesses that receive those payments from the consumer. For example, mobile phone contracts.
Fringe alternative data – data about a consumer’s behaviour, often non-financial. There is growing availability of substantial streams of data which is driving new forms of behavioural analysis in scoring models, such as psychometric testing. These methods have the greatest potential to bring large numbers of consumers into credit markets by making them ‘scoreable’.
Assessment of the value of alternative data remains a fast-developing area. A growing number of recent reports have demonstrated the potential positive impact of inclusive credit scoring.
The impact on financial inclusion
We cannot automatically assume positive financial outcomes of inclusive credit scoring. Recently, ‘predatory inclusion’ and ‘adverse incorporation’ has accompanied the extension of consumer credit markets. At the same time, high risk consumers can face ‘scoring inclusion’ but continued market exclusion, and struggle to improve a thick file of adverse data points. However, this could enable mission-oriented affordable lenders and inclusion-driven policy initiatives to target these consumers.
Despite this, the drive for inclusive credit scoring aims to more accurately reflect ‘true’ creditworthiness, allowing for more appropriate provision of credit. It supports fairer access and financial inclusion, and it is essential for credit reference agencies to step up to the challenge and begin to take their role in financial inclusion seriously.
Given the pace at which financial lives continue to change for more and more consumers, it is imperative that mainstream CRAs adopt inclusive approaches. If they do not, financial institutions should turn to fintech alternatives when making lending decisions. Otherwise, they are not only missing out on a market opportunity but also perpetuating financial exclusion.
For further information on mainstream and inclusive credit scoring, read the full report here.