Overcoming the Catch-22 for credit invisibles

To shake the dust off the stale U.S. credit scoring system and overcome the structural problem of credit invisibility, we should be open to global experience.

What Singapore, Hong Kong, Australia and the U.K. are doing regarding fintech regulation is noteworthy. Despite significant efforts in recent years, the current U.S. credit scoring system is still far from perfect. Among American adults, 19% do not have a conventional credit score, including 28 million who are "credit invisible" and 21 million who are unscoreable. An additional 57 million have credit scores that are subprime or below.

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All these people find themselves in a Catch-22 situation: They must first access credit to build a history of consistent credit repayment to demonstrate their worthiness to receive credit. The other side is that opportunities for banks and other lenders to expand new customer segments and develop retail products remain significantly limited.

The issue of credit invisibility is widely discussed in the expert community, including in the pages of American Banker. Moreover, several multidirectional steps have been taken in recent years to address it. However, all these measures are rather a tiny poultice for folks who need a game-changing cure.

The paradigm that most of the currently accepted measures have in common is that past consumer behavior is the best predictor of a consumer's ability to repay a loan. But to find a solution to a systemic problem, it is worth looking beyond the system itself. What if we could predict the behavior of credit consumers based not on their past but on their future?

According to the International Monetary Fund, access to nontraditional data could increase inclusiveness by alleviating adverse selection problems that exclude disadvantaged people from credit markets. Naturally, the use of alternative, primarily behavioral data, can pose risks to consumers, including violations of fair- lending laws, racial or gender discrimination, and data privacy risks.

To mitigate such risks, it is necessary to start by clarifying the rules of the digital economy while ensuring its competitiveness and sustainability. There is still no standard and straightforward approach to global data governance. While the European Union takes a rights-based approach to open data transmission (reflected in the 2016 General Data Protection Regulation), in the U.S., the norm is industry self-regulation, based on the concept of "notice and choice." U.S. data privacy laws tend to be state-specific and apply to a relatively narrow area of ultrasensitive data, such as health care or finance.

Historically, U.S. credit scoring agencies have relied heavily on basic indicators such as income verification, public records and repayment data from lenders, including mortgages, car loans, credit cards or student debts, to assess creditworthiness. It is this highly restrictive approach that has led to structural inequalities in the system.

According to a Consumer Financial Protection Bureau report, low-income, young and minority consumers are disproportionately among those with low credit stories. Black and Latino Americans are more likely to have more limited credit records than white or Asian counterparts. For immigrants coming to the U.S., there is also no quick way to prove their creditworthiness, even if they have a long and spotless credit history back home. This inequality between racial and ethnic groups emerges early in these consumers' adult lives, persists thereafter and never disappears.

Outside the U.S., there are some notable examples of state and other regulatory entities working in collaboration with business leaders to address challenges and opportunities in our rapidly growing industry.

Australia's Department of the Treasury, in part responsible for market regulation there, put forward a consultation paper to elicit feedback on new regulatory options that will impact the Australian buy now/pay later sector.

In 2016, the U.K. Financial Conduct Authority launched a Regulatory Sandbox to provide innovators — both incumbents and new players — with access to regulatory expertise.

The Monetary Authority of Singapore launched a Smart Financial Centre through FinTech and Innovation which now has over 40 innovation labs that host in excess of 1,000 fintech firms, and which facilitated a record-high $3.9 billion (USD) fintech investments in 2021.

Finally, in June 2021, the Hong Kong Monetary Authority unveiled "Fintech 2025," its new strategy for driving the country's fintech development.

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In comparison, the U.S. is lagging, with some notable exceptions. Indeed, two years ago, in December 2020, the CFPB issued rules that made it somewhat easier to use alternative data in credit scoring and gave lenders additional flexibility in assessing a consumer's ability to repay a loan.

The implementation of such solutions is seen in the market: Fannie Mae updated its automated underwriting system to include rental payments; JPMorgan Chase, Bank of America and several other major banks launched an initiative to offer credit cards to people with no credit history but with regular monthly utility payments or rent; UltraFICO or Experian Boost allow consumers to build their alternative credit score by obtaining transaction data from deposit accounts or credit cards to identify the mobile phone, utility and other recurring payments.

There is also growing momentum for buy now/pay later installment loan companies to start sharing borrower data with credit reporting companies to increase the transparency of the risks that these loans pose.

However, to be truly effective, such alternative streams of data must be collected across the market, and it could take years to make serious headway. Furthermore, such data-sharing initiatives are presumably not helping to overcome structural inequalities for marginalized groups: it will benefit the most highly paid young professionals and recent immigrants with healthy current account balances.

I am confident the industry will continue to develop exciting new technologies, but these developments need to be met with a more responsive legal and regulatory framework. Governments and businesses will both benefit from a more robust and up-to-date perspective on financial technology. Ultimately, these technologies are made to bring more people into the worlds of banking and finance, granting credit based on how people actually behave in the real world, and not how they appear on paper.