Alternative data could be a lifeline for consumers in need of credit

Two bills recently introduced by House Democrats as part of broader coronavirus relief efforts aim to protect consumers by imposing a moratorium on negative credit reports.

While they are undoubtedly well-intentioned as consumers in debt face financial problems, these bills (HR 6321 and HR 6379) could unnecessarily affect the safety and soundness of lenders across the country. And they could eventually lead to bank failures, loss of access to credit and therefore, unintentionally, harm the consumers that these bills seek to protect.

Consider that banks and other creditors use credit reports to make lending decisions. When debts do not appear on a report, a creditor cannot accurately judge the borrower’s repayment capacity. If debts are not reported to consumer credit bureaus, lenders cannot make informed underwriting decisions.

Potentially, this means that a person could take a large loan from one bank and then take an equally large loan from another institution, even though that borrower has no realistic ability to repay both. This type of loss can add up quickly.

And history tells us (like the crash of the late 1980s and the financial crisis of 2008) that bankruptcies and bank failures follow such losses. A Congress which will not learn from this history is doomed to repeat it.

The way to protect the credit of consumers affected by the coronavirus pandemic is not stopping reporting. Rather, it is by reorganizing credit scoring models that only take into account payments and no other alternative data models. This means having a rating system that takes into account human behaviors and the consistency of those behaviors, as a positive rating mechanism.

Instead of looking to see if consumers have missed payments in this period of national emergency, credit scores should reflect consumers’ propensity to repay, rather than the binary consideration of whether they pay on time this month or over the next few months.

A Federal Reserve Economic Report 2019 found that 6% of adults were “unbanked”. This means that they did not have a checking account, savings or money market. And half of the unbanked have used some form of alternative financial service, like a payday loan or a tax refund advance. The study also found that 16% of adults were ‘underbanked,’ meaning they had a bank account but also used an alternative financial product. These two populations are considered to have more non-privileged borrowers.

However, alternative credit scoring models have been developed to assess this population and provide access to credit. Alternative credit scoring models consider “validation” data as opposed to pure “verification” data, such as repayment history.

Historically, traditional scoring models have used audit data as data that exists in written or tangible form, either through consumer-produced documentation or through a third-party database. One of the shortcomings of verification models is that they do not take into account cash income.

Conversely, validation data models can compare the income and expense values ​​reported by consumers to statistical distributions to determine the level of confidence in the reported data. Validation data can come from historical information or geographic average values ​​for consumers in the same situation.

Alternative credit scoring has been around for over a decade. The World Bank Group has studied the usefulness of other scoring models for microcredit in emerging countries and found in 2019 that only 20% of available data is actually considered by credit reporting agencies as Easily readable “structured data”.

Alternative models also take into account ‘unstructured data’, which can be better used to understand consumer behavior and experiences. For example, data on mobile payments and / or generated by mobile devices creates huge amounts of information that could be used for financial inclusion.

Think about mobile devices and communications between consumers and lenders. A delinquent consumer but constantly expressing his difficulties could be assigned a positive rating to better assess his solvency according to his desire and his payment effort. Meanwhile, a delinquent consumer who fails to communicate could be given a less than positive score.

The fintech industry frequently uses rating via alternative models because it is better for consumers, especially in these difficult times. Banks are also starting to understand this.

If Congress simply imposes a moratorium on negative credit reports, it will likely lead to bad, uninformed loan decisions with serious consequences.

However, if Congress enforces the use of alternative rating models – or simply prohibits lowering credit ratings during this time of national emergency – they will do a much better job of protecting consumers and fueling the recovery.

Barbara Sinsley is Legal Director of Remitter USA and meldCX. Previously, she was legal counsel for FactorTrust, a credit reporting company that used alternative credit scoring models. She is a recognized expert on laws affecting the credit and collection industry.

Manny Newburger leads the Consumer Financial Services Law Practice Group at Barron & Newburger PC. He has a national practice in consumer protection litigation, regulatory matters and compliance. For 22 years, he taught consumer protection law at the University of Texas Law School.

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