The Future of Credit Scores

This article is a study of the current approach of determination of creditworthiness, the missing chinks in its armor and explores solutions that could be popular in the future.

The need of a Credit Score

In the loans industry, creditworthiness of the borrower is of prime importance to the lender. In simple terms, the lender always worries whether the money lent will come back, along with the cover up for all costs of disbursal and lastly earn a little bit of margin. All these factors are together termed as ‘risk’ in the lender’s eyes. The more the risk, the more ‘costly’ it is to recover the money, and thus higher the interest rate on the loan. In an industry with cut throat competition, where there are several players, each basis point matters. And from the borrower’s perspective, the ‘safe’ borrowers or the ones who will surely return the money along with due interest, consider themselves ‘less risky’ and thus, demand low interest rates. And since it is difficult to identify who is risky and who isn’t, it represents the classic Lemon’s problem. Thus the solution is to call for a numeric figure: a simple credit score determining credit worthiness. Just like your kid’s scorecard determining her performance at school. Except that, credit scores are not that simple!

How is this Score calculated

The FICO score, popularly used in the US comprises of five major factors:

Source: Wells Fargo

In India, the Credit Information Bureau (India) Limited (CIBIL) providing the CIBIL score is the most popular in the loan market. In 2000 some of the now-partner banks decided to come together to form an independent organization, CIBIL that would generate a credit score for determining credit worthiness of individuals and organizations.

The Issues with this approach

While this traditional approach gives a fair accuracy, there are certain concerns related to it. For starters, the CIBIL considers past history of payments made and decided if a person is credit worthy. As per the Credit Information Companies (Regulation) Act, 2005 governing Credit Information Companies, all accounts irrespective of their status (both Good Standing and Delinquent accounts) have to be maintained for a minimum period of 7 years from the date the account was last reported. Now 7 years is a long, long time in this fast-paced world. Take for example a friend of mine. About 5 years ago, he had missed a small credit card payment of approx Rs. 500, and CIBIL score naturally got a big hit. He laments, “My salary has almost tripled in the past 5 years and I have jumped 2 levels of promotion, but I cannot get a car loan of 5 lacs due to that one error!”

Also, every year a staggering 8.7% of India’s 1.25 Billion population enter the workforce (Source: Government Census). This number is only going to grow in the coming years: both in base population number and percentage. This means that every year, there is a huge number of people who are without a credit history. Essentially, the Credit Institutions (CIs) who rely heavily on CIBIL and do not process loans or credit cards without a history, miss out heavily on this opportunity.

Further, there a number of other issues like dependence of the banks to update the CIBIL history of each individual correctly, at specific time intervals. Any discrepancy with the score needs to be taken up by the individual, who needs to be aware of the procedure and steps. And one actually realizes that there may be discrepancies only at the time of need of credit; the resolution of which could take longer than the time of the need. Also, CIBIL essentially hugely assumes that credit behavior will not change throughout the life of an individual, or at least for the next 7 years, which is debatable.

The Solution

In the age of ecommerce and Big Data, a combination of a lot of information can replicate a typical creditworthiness score like Cibil. Along with that, qualitative factors like how one spends one’s income, what percentage of that comprises of savings, what percentage of savings go into risky investments are better indicators of whether the individual will actually return the borrowed amount on time.

For individuals newly entering into the workforce, a few indicators are education, job, peer group, etc. which can be easily and smartly verified by social networking media like Facebook, LinkedIn and Twitter. People are generally truthful about their backgrounds on social media rather than a loan application form, because of the social stigma associated with it. It is the same stigma that works for lending in rural areas, where there is no concept of a credit score. In a way, this approach is more traditional, with thorough background checks in rural places, where the moneylender essentially knows the whole village!

Further, with increase in digital wallets and in number and scale of online transactions, it is very easy to track all expenses for an individual. The government-backed RuPay scheme and financial inclusion plans will only enrich the information already available, in both, quantity and quality. There is a lot of data on how and where expenses are made, for decision making not just on creditworthiness, but also for several other things like insurance.

Most of this data acts as a surrogate of a credit score, when it is not easily available & for quick decision making. While such an idea is still in its nascent stage and will require regressions with the actual score, with high accuracies, it can certainly be used along with a credit score for faster & more relevant decisioning. In the future, the combination can ultimately solve the lemons problem in the lending industry, and strengthen the concept of discriminatory pricing in terms of interest rates offered, leading to maximum efficiency.

There is a potential opportunity in this domain to be explored. A lot is already being done by innovative P2P lending firms, online marketplaces like RupeePower and BankBazaar and even in micro-lending, and a lot more can be done. It would be interesting to observe how these organizations transform in the future, and bring disruptive changes to the financial industry!