It may take time and regulatory easing for depositories to emulate organizations like SoFi in transitioning to a “FICO-free” credit scoring model, but there is definite merit in leveraging alternative models to tap into a significantly underserved (yet creditworthy) segment of the population. Developing an alternative credit score or leveraging existing models enables a lender to penetrate this overlooked market and gain new consumers at a time of increased competition and reduced profit margins.
Heightened regulations have increased compliance costs for traditional lending institutions, driving capital constraints and reducing spending for revenue-generating technology projects. This has created an opportunity for new entrants to the market, such as Zest Finance and SoFi; online lenders who are less constrained by regulations since they are nondepository institutions. These new market entrants are leading the steep increase in peer-to-peer lending by utilizing alternative credit scoring models to provide access to funds to underserved small businesses and individuals.
An Experian study estimated that 64 million consumers in the United States do not have a FICO credit score. Further, Vantagescore assessed 10 million of these so-called “unscoreable” consumers as prime or near-prime consumers, while another significant percentage have steady jobs and/or low liability levels. Clearly, there is a need to determine creditworthiness outside of the traditional models. Organizations like ScoreLogix, which relies on employment and income date for specific zip codes, and Lenddo, which uses Facebook profiles, are examples of new entrants filling the gap in alternative credit scoring analysis.
Existing credit bureaus such as Experian and TransUnion have responded by developing their own alternative credit scoring models. Similarly, larger financial institutions are also increasing investment in their own custom models based on alternate data as a supplement to traditional FICO scores.
In addition to expanding opportunities to offer tailored products and a friendlier customer experience, alternative data points and algorithms used for credit analysis allow lenders to streamline loan applications and deliver faster loan decisions to applicants.
The traditional underwriting process can also be enhanced by leveraging nonconventional variables such as credit card transactions, social media presence and utility bills. This can potentially reduce credit risk through expanded risk modeling and monitoring. Lenders should consider back testing alternative scoring models as a challenger to compare against the FICO model in a champion-challenger sandbox environment.
Alternative credit scoring presents tremendous opportunities, but it is not without risks and challenges. For example, lenders need to ensure the use of alternative credit scoring complies with regulatory standards like Equal Credit Opportunity Act or Fair Credit Reporting Act.
In addition, governance regarding data accuracy and objective application of the methodology is critically important. The industry needs to recognize that alternative credit scores are more open to manipulation than FICO scores since an applicant could create the illusion of wealth or prominence through clever social network maneuvers, for example.
Lenders can take proactive steps as using alternative credit scoring gains greater acceptance in order to mitigate some of these risks. For instance, lenders should develop a strong compliance program before the implementation of alternative credit scoring in the underwriting process to ensure adherence with all relevant regulations. Staff should be well-trained and knowledgeable in order to quickly identify any risk areas and adapt to evolving regulations.
Data and model calculation is of the utmost importance, and one way to ensure accuracy is to establish an enterprise-wide data governance structure that is cross-functional and includes representatives from all stakeholder groups with decision-making authority. In addition, procedures for ongoing analysis of data groups and their correlation to borrowers’ credit histories should be created.
Compliance teams should conduct regular internal and external audits to ensure that procedures are followed without adverse impact, and test strategies on a representative sample before rolling out across the entire business. Again, champion-challenger testing should be implemented to validate changes to the organization’s decision logic and risk policy.
Roadblocks and challenges aside, big data and advanced analytics are firmly ensconced as critical focus areas for the technology providers for the next decade. Industry players who are able to leverage the power of technology to create congruent business processes and solutions will emerge as the new thought leaders of the industry. A combination of new data sources, supporting technology and regulatory conditions and an innovative yet safe approach to products and offerings is the perfect storm to transform the current housing finance market and potentially, charge the economic engine of the country.
Adi Ghosh is a director focused on the primary and secondary housing finance market, and Harsh Sharma is a business consultant, with Sapient Global Markets based out of Washington D.C.