The Future of Consumer Credit Management (incl. Credit Reports & Credit Scoring)
Credit is a very important aspect of our financial lives.
Many of us would not be able to function well financially if not for the ability to access credit when we need it.
That’s why we are so keen to ensure we always have a good credit score.
We pay our credit card debts and bank loans in time to ensure our credit score is exemplary, which in turns makes it easier for us to access credit the next time we need it.
Have you ever considered the nitty-gritties behind the consumer credit management systems that credit card companies and other lenders use? Do you know how your credit score is calculated?
Are you aware that credit bureaus such as Equifax contain all or most of your credit history as well as other personal information like your social security number and address?
With technology advancing at a rapid rate, lenders have started capitalizing on these advancements to pioneer revolutionary solutions to the problems they encounter in consumer credit management.
Lenders have also started using alternative data – such as social media data – to calculate your credit worthiness.
How do these changes affect you as a borrower?
In today’s article, we are going to cover all this and more to help you understand consumer credit management, where it is coming from, and where it is headed, particularly with technological evolution and the spawning of ever sophisticated legislation and regulations.
WHAT IS CONSUMER CREDIT?
Consumer credit management is a system of methods and practices that financial services organizations use to manage their credit relationships with customers.
The simple definition of consumer credit is when a customer takes on personal debt to facilitate the purchase of goods and services.
Another name for consumer credit is “consumer debt”.
One familiar example of consumer credit is the credit card.
While any type of personal loan could technically be called “consumer credit”, the term typically refers to unsecured debt which one takes on to purchase everyday goods and services.
In that case, a personal loan taken on when purchasing a house would not be termed as consumer credit since a house is a long-term investment. Houses are typically bought using a secured mortgage loan.
Organizations that extend consumer credit include banks and retailers.
They do this to help customers to buy goods instantly, even if they don’t have enough funds to purchase the goods at that moment. The customer then pays off the cost with interest over time.
Consumer credit has its advantages and downsides, which are highlighted in the video below.
There are two main types of consumer credit:
- Installment Credit – This is credit provided for a specific purpose. The amount of credit is defined and given for a set time period. Payments for installment credit are typically made monthly in equal installments. This type of credit is mainly used when making big-ticket purchases such as cars, major appliances, and furniture. The interest rates for installment credit are typically lower than those of revolving credit. The item you purchase with the credit will serve as the collateral, in case you default.
- Revolving Credit – A good example is credit cards. You can use credit card for any purchase. In other words, the credit is “revolving” because it is open – the amount of debt you owe fluctuates as you use up the available credit and make repayments. You can use up to the maximum limit over and over again, provided you continue making your minimum monthly payments in time. Revolving credit has a high interest rate because it is unsecured credit – it is it is not secured by collateral.
The appetite for consumer credit among Americans has been growing over the years, as evidenced by the graph below.
THE EVOLUTION OF CONSUMER CREDIT AND THE EFFECT OF TECHNOLOGY
Consumer credit has been evolving since the days of the Sumerians.
It has been around for at least 5,000 years! The Sumerians had the first urban civilization, and they used consumer loans for agricultural purposes.
However, it was not until a century ago that consumer credit started to make big leaps and bounds.
When Henry Ford realized that most American families were not wealthy enough to purchase automobiles with cash, he struck on an ingenious solution.
General Motors began to loan its customers the money they needed to purchase a car.
This popularized the concept of installment plan financing.
Other companies followed GM’s lead, and people were able to buy furniture, phonographs, refrigerators, and radios on installment plans.
However, this system was inefficient and inconvenient because one had to have several credit accounts with different merchants – each with its card and monthly payment.
In the fifties, credit cards were introduced, enabling Americans to access general credit for a wide variety of purchases.
In the sixties, computer technologies were applied to credit reporting, resulting in improvement of data accuracy due to standardization of credit application forms.
Thanks to the information age and the evolution of technology over the decades, consumer credit and risk assessment processes have grown and are constantly changing to accommodate the changing world.
For instance, credit reports are today instrumental in making informed decisions about insurance, employment, housing, and cost of utilities.
Modern credit systems operate with sophisticated algorithmic credit scoring.
They use trended and alternative data, and feature innovative fintech applications.
When all these developments combine, they provide the technological foundation for even greater evolution and improvement of consumer credit management in future.
The most common credit scoring model in use today consists of five categories: payment history (which makes up 35% of the credit score), debt burden (which makes up 30% of the credit score), duration of credit history (which makes up 15% of the credit score), types of credit used (which makes up 10% of the credit score), and new credit requests (which makes up 10% of the credit score).
This traditional scoring model has its limitations.
For instance, traditional credit scores provide a credit snapshot instead of portraying the bigger picture of how the person’s credit is changing.
Furthermore, the traditional model may give an inaccurate representation of a customer’s credit due to a lack of data, inhibiting the person’s current score.
Fortunately, technology is helping to weed out these inefficiencies.
Trended data enables analysis of the velocity, direction, tipping points, and magnitude of changes in a customer’s credit history.
This provides a more accurate picture than what you get from looking at a snapshot of the person’s credit score.
Trended data improves predictive performance by up to 20%.
Credit history, though important, is not the only source of data that can shed light on a customer’s creditworthiness.
Alternative data includes information on wealth, property ownership, the customer’s payment of daily bills, among other data sources.
The sum of all this data provides a more comprehensive picture which enables credit-giving companies to better judge a customer’s creditworthiness.
Thanks to technology, consumers have access to an unprecedented level of their credit data.
Furthermore, new science involving neural networks is being implemented to add more sophistication to the credit scoring process.
THE FUTURE OF CONSUMER CREDIT
As a borrower, there is more to you than just your credit score.
For creditors to eliminate the inefficiencies in their credit scoring model and enable highly accurate predictions, they must get a 360 degree view of their customers’ creditworthiness.
The gap between your actual creditworthiness and what the creditor is able to figure out is known as “information asymmetry”. Over the years, as technology advances, this gap has continued to grow smaller.
However, there are situations where information asymmetry lingers.
For instance, in the case of a college student that has zero credit history, or a farmer in rural India needing a loan to buy seeds for his farm.
Due to the increasing amounts of data and the development of technology which can utilize that data, information asymmetry will be tamed in the new future.
The following are the major forces that will reduce information asymmetry and influence the future of consumer credit:
1. Increasing Data
The rate of global data creation has grown in leaps and bounds and is ever increasing. Credit companies will improve on their ability to access consumer data and to interpret it accurately.
Consider that the following staggering amounts of data are created daily on the internet:
- 500 million tweets sent
- 4 petabytes of data created on Facebook (a petabyte is a quadrillion bytes – note that a quadrillion contains 15 zeroes)
- 294 billion emails sent
- 65 billion Whatsapp messages sent
- 4 terabytes of data created from each connected car (a terabyte is a trillion bytes)
- 5 billion searches made
It is estimated that by 2025, the globally daily data output will be 463 Exabytes (an Exabyte is a quintillion bytes – note that a quintillion has 18 zeroes).
Today lenders have already started using social media data for credit scoring. Social media data is useful for assessing the creditworthiness of thinner-file borrowers like students and foreign nationals.
Innovative lenders are using alternative data sources such as social media, bank transactions, cell phone data, and third-party hubs that package personalized and verifiable data for the lenders.
With this information, lenders are able to increase their approval and conversion rates, and expand their base of customers to include under-banked populations.
It also enables lender to give their customers a customized experience based on the deep insights they draw from the customers’ profile.
Furthermore, lenders are able to reduce cases of fraud by identifying potential fraudulent activity.
Using social media data for credit scoring is very helpful in countries which have limited credit bureau data, where huge sections of the population are accessible only through such alternative methods.
The use of alternative data will continue to expand and advance with time, as more sophisticated technology and algorithms are created to help make the best use of this data.
However, these strides towards use of alternative data will have to contend with increasingly sophisticated laws put in place to protect personal data and privacy.
2. Changing Regulatory Landscape
New international data regulations such as the GDPR are putting data back in the hands of consumers and that will definitely have an impact on the future of consumer credit management.
GDPR, which stands for General Data Protection Regulation is an EU region data protection and privacy regulation that took effect on 25th May 2018. Its aim is to give back control over personal data to people in the European Union and European Economic Area (EEA).
It simplified the regulatory environment that international businesses have to operate in by unifying the regulation within the EU.
While lenders are increasing making use of alternative data for credit scoring purposes, data protection laws can put the brakes on such innovations.
Ultimately, the future of consumer credit management is dependent on this struggle between data protection regulation and the move by lenders towards using alternative data.
Data protection laws are not the only regulation lenders have to contend with. The regulatory environment is becoming increasingly complex.
It is estimated that by 2020, about 300+ million pages of regulatory documentation will be published.
For that reason, lenders are increasingly relying on RegTech (regulation technology) solutions to help them achieve compliance with this mountain of laws and regulation.
While today a lot of our financial data is almost exclusively in the hands of credit agencies and banks, in future a lot of the data will be in our control as consumers. We will make decisions on how our data is used and for what purposes. Initiatives such as GDPR, PSD2, and Open Banking are meant to make that vision a reality.
While it has already started in Europe, the trend towards open data is expected to go global.
With open data, we as the consumers will be able to:
- Get back control of checking, credit card, mortgage, and loan data.
- Voluntarily give up more information so as to receive better deals from creditors.
- Give third parties access to use this data in new products and applications.
- Access better rates, new lending models, and so forth.
3. Emerging Technology
Game-changing technologies such as neural networks, deep learning, and machine learning are making it easier for companies to draw deeper insights from data.
Big Data enables the collection of data in incredibly high volume, velocity, and variety – both structured and unstructured data – that traditional processing applications were unable to handle.
Big Data has highly simplified the lending process and made it faster and more convenient for customers.
For instance, borrowers don’t have to personally go to a bank or interact with a bank representative to get the service they need.
They can access lending services online. Big Data has also helped reduce the approval process to a minimum because it enables lenders to calculate risks faster, even without paperwork.
RegTech (regulation technology) involves using technology such as blockchain, biometrics, and AI to enhance and improve delivery of regulatory requirements. Lenders in the US are spending large sums of money every year on such technology to help them comply with the changing regulations.
Machine learning is a branch of artificial intelligence. It’s a process where data is analyzed with the intention of learning and creating analytical models which can execute intelligent actions on unseen data with little or no intervention by a human. Lenders are using machine learning to enhance their credit scoring systems. These systems use neural network modeling to enable more accurate risk assessment.
4. Focus on Identity
As you can garner from what we have explained so far, consumer credit management is becoming increasingly digitalized.
One of the disadvantages of this is the great risk of identity theft. In this brave new world, consumer credit management will have to evolve the methods used to authenticate the identity of customers. Technology applications such as blockchain and biometrics may have a role to play.
Biometrics is technology that enables identification of individuals through their unique physical attributes, and includes technologies such as:
- Fingerprint verification
- Iris verification
- Facial recognition
- Voice ID
Biometrics is a strong, convenient, secure, and accessible means of authentication and helps do away with passwords, ID cards, and in-person or paper-based proof of ID processes.
Blockchain is the technology underlying cryptocurrencies like Bitcoin, but its applications are broader than that. It is one of the new frontiers in technology which have the capacity to change the world over the next decades.
Blockchain is able to control information and avoid duplication.
This makes it potentially useful for making self-sovereign identity a reality – that we can control our personal data no matter where we are.
Self-sovereign, digital identities stay under your control, and are capable of quick, secure validation without requiring a centralized repository.
Self-sovereign identity is something that could be used to end identity theft and deal with other issues which impact on consumer privacy.
Fintech is financial technology. The term refers to emerging technologies which improves and automates financial services’ delivery and use.
It helps companies, entrepreneurs, and consumers to improve how they manage their financial processes, operations, and lives.
One of the advantages of fintech is that its high ease of use and convenience makes it a big hit among all sorts of people, enabling companies to access large new portions of customers who are otherwise unbanked.
Such customers have thin credit files and are as a result often given low or no composite credit score.
Fintech lenders use nontraditional data to make better decisions about thin-file borrowers who would otherwise not have access to loans.
Fintech also enables democratization of data and tech which allows small/niche players to enter the industry and provide new, innovative products/solutions to consumers.
CREDIT BUREAUS, CREDIT REPORTING, AND CREDIT SCORING
Credit reports are made by credit bureaus. A credit report is a detailed breakdown of a person’s credit history.
Credit bureaus are agencies which specialize in the collection of such financial information and then preparing credit reports that lenders can then use to determine the creditworthiness of a borrower.
Examples of credit bureaus in the US include Equifax, TransUnion, and Experian. They create reports that cover individuals’ personal financial detail and also your bill-paying habits.
The credit report will have personal information like your current and previous addresses, your employment history, and your social security number.
It will also feature your credit history summary – for instance how many bank or credit card accounts (and type) you have that are past due and how many in good standing. It also covers account information in detail: date the accounts were opened, credit limits, and high balances.
The main problem with credit reporting and credit bureaus is that these organizations contain the information of practically everyone: credit cards, debt, and other accounts payable.
Due to the sensitive nature of this information, and the fact that it is all centrally organized, credit bureaus and credit reports are enticing targets for hackers.
In 2017, Equifax, one of the three US credit bureaus, experienced a serious data breach, exposing the financial data of close to half of all Americans to hackers.
The hackers were able to steal the birth dates, social security numbers, and addresses of 143 million Americans. All those people were made vulnerable to identity theft.
This hack revealed the vulnerability of credit bureaus and the flaws of the credit reporting and credit scoring system.
Entrepreneurs are capitalizing on this and developing better solutions to this problem.
The main problem with credit bureaus is that they don’t exist for our benefit as consumers – we don’t have control over our file and cannot contribute any data to it.
These credit files are backward-looking instruments, which is an imperfect model, and entrepreneurs such as Shivani Siroya, CEO of Kenyan company Tala, are using big data and machine learning to create a new generation of credit applications that use forward-looking data and predictive models rather than rely strictly on past performance.
With predictive data models, consumers can proactively demonstrate their credit potential.
Furthermore, they do not need massive aggregation of personal data, thus not as vulnerable to identity theft as traditional credit reports and credit scores.
Predictive models are beneficial to lenders too as they help expand the customer base by identifying millions of under-served consumers who may be trusted.
For instance, Tala is able to predict creditworthiness of an individual within about 20 seconds, using data present in the customer’s device.
In the wake of the Equifax breach, lawmakers have attempted to place restrictions on credit bureaus, in a bid to make them more secure and transparent.
It is quite possible that in future a credit file could become something similar to a LinkedIn profile: verifiable and reality-based, yet controlled by you, not the platform.
The future of credit files is for consumers to get more control over their data.
Due to the advancing capabilities of technology in machine learning, Big Data, blockchain, biometrics, RegTech, among others, consumer credit management is changing rapidly.
New regulations and data protection laws are also further complicating the plot.
For now we can only speculate what consumer credit management will look like tomorrow.
What is clear for now, however, is that it looks promising for borrowers and will put greater control in the hands of consumers. It is certainly a brave new world we are stepping into.
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