Recapturing the Lost Art of Consumer Credit Risk Assessment

As the country recovers from the physical and mental health implications of the COVID-19 pandemic, the economic consequences could affect consumer financial health and credit underwriting for years to come. The Federal Reserve recently questioned the efficacy of traditional scores over the next few years. Their general point is this: The industry could face a systemic risk if and when credit tradeline data changes in value as a direct consequence of COVID-19 programs and effects. When consumer underwriting decisions rely on tools limited to credit report tradeline history, credit decisions can become less effective and credit products less accessible or more expensive. Luckily, financial institutions can access much more information than what’s in a traditional credit score. That’s where alternative data comes in.

The COVID New Normal

Consumers and businesses have had to adjust to the work from home economy that stemmed from the pandemic. There has been clear division in how the pandemic impacted consumer financial health. For those who maintained their sources of income, the reduction of expenses related to travel, entertainment and dining have served as something like a salary increase they could use to pay down debts or increase savings. For people negatively affected by the pandemic, like those in the service industries – restaurants, hotels and retail – the results have been far less favorable. Those negatively impacted have relied on federal, state and regional stimulus programs and may have relied heavily on banking products to help weather the storm.

Historically speaking, access to affordable banking products relied greatly on credit history. A single significant financial disruption such as a job loss or death of the family’s breadwinner could lead to bankruptcy, impacting consumer financial health for seven to 10 years.

During the pandemic, one program that was particularly helpful in weathering the financial storm was forbearance, which gave consumers leeway to skip payments to financial institutions without expenses or any negative reporting. Forbearance also helped consumers prioritize their spending by deferring payments without incurring fees or long-term damage to their credit history.

These two factors, financial stress and forbearance, have each impacted the value of tradeline-based solutions in determining a consumer’s overall ability to pay. As a result, overall default rates may increase with time to the extent that lenders rely solely on these products and services.

Tradeline Data May Not Create a Robust Picture

COVID-19 has also led to credit tradeline data being less reflective of financial health, a problem that led the Federal Reserve to question the value of credit tradeline data, which credit agencies use to describe balance, delinquency and account information for each credit account listed on credit reports. For those that did not opt into forbearance, situational credit blemishes might underestimate a consumer’s creditworthiness due to events outside of their control. For these consumers, traditional credit scores based on tradeline data could drop.

For those who opted into forbearance, credit information about financial stress will not appear on credit reports, even though the consumer’s overall debt increases. In these cases, scores based on credit tradeline information alone could underestimate one’s financial health.

This is the systemic risk the Federal Reserve referred to. If credit tradeline data doesn’t entirely reflect consumer credit health, the scores based on this data are less effective. Consumers may then have less access to credit or may endure increases in the cost of credit. These trends could threaten customers’ access to affordable credit and lenders’ ability to issue affordable credit because unreported credit risk drives up credit default rates.

This is the perfect storm of systemic risk. The pandemic increased a financial stress in which the industry reliance on traditional credit tradeline data has hampered consumers’ ability to provide the necessary tools to weather the storm.

Bringing Alternative Data to the Forefront

It’s in times like these that responsible credit underwriting is best served by broadening the information available to the underwriter. This provides a better view into a consumer’s long-term creditworthiness rather than relying on a single moment in time where tradeline data is affected by a variety of “noisy” credit events that can hide actual consumer risk. This increase in systemic risk is unsettling.

Many consumers who didn’t have a credit footprint prior to the pandemic suddenly need access to financial products. These consumers have sought out banking products in high volumes. In these cases, credit invisible or thin-file consumers were likely denied affordable credit products or pushed to much more expensive subprime products.

The solution to these risks is for lenders to invite other robust data sources into the decision-making process. Alternative data such as public records and property ownership records may provide additional information about a person’s overall creditworthiness beyond their specific tradeline behaviors. This data also adds depth to decisions based on traditional credit tradeline data by indicating high- and low-risk behaviors outside of a consumer’s wallet. Lenders could then make more refined decisions based on the combination of broader data elements in which traditional tradeline data is a piece of the decision rather than the sole driver of the decision.

By opening the process to other predictive elements like FCRA-compliant alternative tradeline and non-tradeline credit event data (such as property ownership, address stability and economic health) lenders could make responsible lending offers to consumers that are currently disenfranchised by the existing credit system or impacted by the pandemic.

Given the current data landscape, it makes sense to broaden the data used in credit decisions. By diversifying the information in a decision, the impact and efficacy of any particular score becomes less impactful to that decision. Overall systemic risk of single source decision making can decline dramatically.

Alternative Data Helps Banks Lend to More Consumers

This is where alternative data is helpful. Alternative data also may serve as a replacement to traditional credit tradeline data when such data is unavailable. It may also help certain consumers — especially credit invisible groups — emerge from their less desirable credit status. Many of these consumers could then open affordable credit accounts, purchase cars and homes or use a credit card with reasonable terms. For example, a LexisNexis Risk Solutions internal review of bank product applicants showed that the use of alternative data booked 35% more consumers than a traditional credit reporting-based strategy.

The use of alternative data may also reduce the systemic risk of underwriting campaigns across the industry. It’s one of the best defenses against systemic risk presented by single source decision making, based on credit tradeline data. This is especially true as the Federal Reserve and the industry question the efficacy of the data in supporting the post-COVID economy.

Alternative data needs to be a key part of underwriting decision-making strategies now more than ever. This data may provide increased predictive value when used with a traditional tradeline-based credit score and enable scoring of many consumers who can’t attain credit scores using traditional credit data alone. That fosters an environment of inclusion, something all financial institutions and governments should strive for.

Jeffrey Feinstein is vice president of global analytic strategy for LexisNexis Risk Solutions based in Alpharetta, Ga.