Alternative data could be lifeline for consumers needing credit

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

While undoubtedly well-intended as debt-laden consumers are facing financial woes, these bills (HR 6321 and HR 6379) could unnecessarily affect the safety and soundness of lenders throughout the country. And they could ultimately lead to bank failures, the loss of credit access and therefore, unintentionally harm the consumers these bills seek to protect.

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

Potentially, this means a person could take out a large loan at one bank and then take out an equally large loan at another institution, even when this borrower lacks any realistic capacity to repay both. That type of loss can add up quickly.

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

The way to protect the credit of consumers adversely affected by the coronavirus pandemic is not a cessation of reporting. Rather, it’s by revamping the credit scoring models that consider only payments and no other alternative data models. This means having a scoring system that factors in human behaviors, and consistency of those behaviors, as a positive scoring mechanism.

Instead of looking at whether consumers have missed payments during 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 in the next few months.

A 2019 Federal Reserve economic report found that 6% of adults were “unbanked.” Meaning, they did not have not have a checking, savings or money market account. And half of those unbanked used some form of an alternative financial service, like a payday loan or a tax-refund advance. The study also found another 16% of adults were “underbanked,” meaning they had a bank account but also used an alternative financial product. Both of these populations are considered to have more nonprime borrowers.

Nevertheless, 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 verification data as data that exists in written or tangible form, either by way of documentation produced by the consumer or a third-party database. One shortcoming of verification models is that they do not consider cash-based income.

Conversely, validation data models can compare consumer-stated income and expense values to statistical distributions to determine the level of confidence in the stated data. Validation data can be sourced either from historical information or from geographic average values for similarly situated consumers.

Alternative credit scoring has been around for more than a decade. The World Bank Group has studied the utility of alternate scoring models for microloans in emerging countries and in 2019 it found that only 20% of available data is actually considered by credit reporting agencies as easily readable “structured data.”

Alternative models also consider “unstructured data,” which may be better used to understand consumer behavior and experiences. For example, data on mobile payments and/or generated by mobile devices creates enormous amounts of information that could be used for financial inclusion.

Consider mobile devices and consumer communications to lenders. A consumer who was delinquent but constantly communicated their hardship could be given a positive score to better assess creditworthiness as a function of desire and effort to pay. Meanwhile, a delinquent consumer who failed to communicate could be given a less-than-positive score.

The fintech sector frequently uses scoring through alternative models as it’s better for consumers, especially in these difficult times. Banks are beginning to understand this as well.

If Congress simply places a moratorium on negative credit reporting, it will likely lead to uninformed, bad lending decisions that will have serious consequences.

However, if Congress mandates the use of alternative scoring models — or simply prohibits lowering credit scores during this national emergency period — they will do a much better job of protecting consumers and fueling the recovery.

Barbara Sinsley is chief legal officer for Remitter USA and meldCX. She previously served as general counsel of FactorTrust, a credit reporting company that utilized alternative credit scoring models. She is a recognized expert in 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 has taught consumer protection law at the University of Texas School of Law.