Statistical credit scoring programs suffered a crushing blow a few weeks ago when Bank of New York turned down a credit card application for Federal Reserve Board Governor Lawrence B. Lindsey.
Mr. Lindsey was denied a Toys 'R Us credit card because of too many credit inquiries on his accounts.
The result of all this flap will be what we can now call the "Larry Rule" - that if the prospective cardholder has a lot of credit inquiries, you had better check out why, rather than simply denying the credit.
To put it another way, from now on the computer results of the credit scoring of prospective cardholders will be examined and verified by a human being - especially at Bank of New York.
Don't you wish you were a fly on the wall in the office of the president of Bank of New York when he found out that Fed Governor Lawrence Lindsey had been denied credit by his bank? There probably was an interesting conversation with vice presidents of the bank (or possibly former vice presidents).
This is not a good way to get free publicity nationwide and internationally.
Credit scoring's statistical systems are utilized to eliminate arbitrariness, capriciousness, and individual judgment. They have been developed to provide high-volume, low-cost, instantaneous credit application decisions.
Yet, as you can see clearly from the incident with Mr. Lindsey, the results are not necessarily perfect.
In this particular case, the gaffe arose out of a statistical variable that has been suspect for years.
In my younger days as a college professor, I used to observe to my banking students that most of the credit scoring variables used by financial institutions and other nonbank installment loan lenders were individually oriented and controllable.
In English, this means that you and I as consumers dictate the credit scoring information by our past and current activity. How much we borrow, how often we pay it back, how often we are past due, how often we've had legal actions imposed upon us, and our general credit history - these factors are under our direct control.
On the other hand, the number of credit inquiries - the reason that Mr. Lindsey was denied his Toys 'R Us credit card - is beyond our control.
You may initiate a credit card or other consumer loan application process that necessitates a credit inquiry. But credit inquiries are often made on our accounts without our permission or even our knowledge - by credit reporting agencies, credit bureaus, and so on. When this occurs, the number of credit inquiries is out of our control.
Furthermore, the statistical barrier called "number of credit inquiries" and some determination that the number has anything to do with the quality of credit or the quality of the customer has always baffled me.
In this particular credit scoring program, the number of credit inquiries by itself flagged the computer, which sent out a rejection letter, all without review or confirmation by bank personnel.
But the number of credit inquiries on our accounts - that is, of attempts to ascertain our creditworthiness - is not indicative of anything.
Our current banks and other lenders inquire about our credit as a part of loan review on a regular basis. They don't tell us ahead of time.
I suspect that certain lenders who desire our business also check out our credit before sending us unsolicited preapproved credit lines based upon our income, geographical location, income grouping, occupational status, and so on.
In fact, my suspicion - that the wealthier you are, the more income you have, where you live, and what your job is about prompt more credit inquiries - is backed by the credit denial to Governor Lindsey.
Mr. Lindsey did not indicate in press releases that his credit was bad. Furthermore, nowhere did he say he had made a series of credit card and other loan applications.
It is my suspicion that a lot of these credit inquiries were voluntarily initiated by current, previous, and even prospective lenders to Mr. Lindsey, without his knowledge.
In some cases, such credit inquiries make sense. All credit inquiries result in past and barely current credit histories, and thus updating is necessary over time and as the individual is involved in a credit relationship with a lender.
However, to deny a person a credit card or some other consumer loan simply because of "a number of credit inquiries" beyond his or her control seems ludicrous.
I can work up a very simple scenario that might cause me trouble without my even knowing it.
Let's assume that, first, I am a small-business owner and have just, through cash profitability, decided to move to another house in my community.
Second, I am in need of a new car. Thus I apply for a loan on one and give two or three financial institutions the opportunity to bid on the rate.
So far we can expect credit inquiries from prospective mortgage lenders as well as prospective automobile financing lenders.
Now, to top things off, in the ordinary course of business life, I need to refinance my business. My line of credit has come up, and I wish to increase it from $50,000 to $100,000.
Guess who's going to make another credit inquiry Of course: my financial institution lender, which is making the business loan.
And if for some reason my line of credit is backed by a mortgage loan, perhaps I will get two inquiries into the credit reporting agency on said business.
Thus in my little scenario I have two mortgage inquiries, two or three automobile loan inquiries, and one or more business inquiries within a short time. And I'm a perfectly creditworthy, solid businessman with nothing outstanding and no problems.
You can imagine this happening to thousands, even hundreds of thousands of individuals throughout the United States every year.
A statistical credit scoring program that simply denies individuals credit because of the number of credit inquiries, whether it be at Bank of New York or Kumquat Credit Union, should be changed.
At the least, there should be a review so the financial institution can determine whether the individual really has bad credit or it's just that people are inquiring about his or her outstanding credit.
So I propose the "Larry Rule" where financial institutions use credit scoring systems:
Any credit scoring programs that result in a proposed credit denial because of "number of credit inquiries" should be automatically flushed from the system and reviewed by a human being.
This doesn't mean that the person will be granted credit. It simply means that someone with more intelligence than a kumquat will have the opportunity to make the mistake personally, rather than having nondiscriminatory, nonarbitrary, noncapricious, and wrong-results-oriented computers.
The "Larry Rule" is simple - either fix the "number of inquiries" problem that is obvious from Mr. Lindsey's situation, or eliminate the number of inquires entirely as a statistical variable in determining creditworthiness.
Mr. Austin is president and CEO of Austin Financial Services Inc., Toledo.