A system set up to fail: consumer credit reporting and scoring needs to change.

New technologies, such as AI and block-chain, help to resolve the main flaws of the current consumer credit industry – vulnerabilities to cyber attack and asymmetric information between participants.

The data breach suffered by Equifax whilst potentially devastating for 145 million consumers has a silver lining. It serves as a huge wake up call to the inadequacies of the way consumer’s financial data is reported, owned and stored by the 3 dominant credit bureaus, Transunion, Equifax and Experian (the “Big 3”). The recent data breach is one of a number of such security failures by an entity entrusted with our most sensitive of information. The reason behind the breach lies in the centralised ownership and control of consumer’s financial data. It’s this centralisation that has enabled the Big 3 to create more than $42 billion of value for investors. This immense fortune has come at a price. Not only is our data not secure from cyber-attack but because of the current credit reporting system [2 billion/ 45 million consumers [worldwide/in the US] are prevented from accessing credit.

The credit bureaus have served a necessary purpose.
The Big 3 and other credit reporting agencies around the world have served an important purpose. In their role as providers of trusted and verified financial information financial service providers, such as lenders, have been able to rely on such information to provide much needed products and credit to hundreds of millions of consumers. Credit scores like Fair Isaac Corporation (“FICO”), (the largest credit score provider in the U.S.) rely on their information to produce their score. In turn, lenders rely on credit scores to make their credit decisions and to determine what interest rate for example a borrower will pay on their credit card or loan. In the U.S. alone 90% of Lenders base their decisions on FICO. It’s clear therefore that credit bureaus are a fundamental part of the consumer credit ecosystem. 

The credit bureaus are incentivised to maintain the status quo.
The basic business model of the credit bureaus is to sell access to financial data. The genius in their model is that the way the current system is configured enables the bureaus to obtain that data for free. Providers of credit such as credit card issuers and other lenders are incentivised to report a borrower’s payment history to the bureaus because that data influences a borrower’s credit score. With a bad a credit score a consumer’s access to credit and even job prospects may be severely compromised. Negatively affecting a borrower’s credit score is the main lever credit providers have to encourage delinquent borrowers to pay. 

The reliance on credit bureaus has created structural weaknesses
The system works well for certain segments of the population and for the most part functions well. The system works best for the entities that effectively created it, the credit bureaus. This reliance however has given rise to 2 systemic issues: (i) marginalization of consumers with short credit histories and (ii) security vulnerability. 

(1) People with short credit history are marginalized by the financial system.
As explained, access to reasonably priced credit is predicated on an individual’s credit score which in turn is normally based off an individual’s credit history as reported by a credit bureau. Those with strong credit history have wide access to credit, such as mortgages, credit cards and auto loans from an array of providers; the competition pushes down rates to very affordable levels. 

Without a strong credit history and resultant strong score is very difficult, if not impossible to access any type of credit, be it unsecured personal or auto loans, mortgages or credit cards. While a low credit score is sometimes fair, the manner in which these scores work often means those with limited credit history, (referred to as “thin files” such as, young borrowers or expats) are unfairly “lumped” with bad borrowers. These populations tend to be viewed as “risky” and often are forced to resort to paying excessively high interest rates or totally denied access to credit which can have dire consequences. The issue is therefore a data issue - just because an individual has a limited credit history as reported by a bureau does not mean he or she is a bad credit risk. 

Many credit histories are “short” because traditional credit bureaus do not use all available data.
No credit scoring system or corporation has a complete view of an individual’s financial profile. Scoring systems such as FICO base their decisions on a limited set of data (reported credit data). Other, alternative indicators of creditworthiness, such as cell phone & utility bills, savings accounts, foreign credit histories, or rent payments are routinely not considered. There exists no secure and reliable depositary for such information.

This means that in many cases data that may be relevant for evaluating an individual’s credit worthiness goes unreported to the major credit bureaus. Examples of these are payments to service companies such cellular telephone companies, electricity providers, and natural gas services. Millions of people with no credit or poor credit scores still pay rent and utility bills consistently and on time. 

Examples of segments of the population most affected by this issue are those new to credit and immigrants. It’s often the case that despite someone graduating from with a university degree and a stable job they are categorised as subprime credit risk. Similarly, immigrants arriving in a new country do not benefit from any credit history they previously built up in their country of origin. This apparent lack of data is a result of the narrow focus of the incumbent credit bureaus. The financial access of millions of consumers would be hugely improved if financial service providers could obtain a more holistic picture of a consumers’ financial health.

At Pave despite using latest artificial intelligence technologies such as machine learning our results were limited by the data on which we based our decision. We found, somewhat unsurprisingly, that specifically for those with limited credit histories, the more alternative data we could feed into our algorithms the more accurate the result. In other words, payment data such as education, rental, utility and cell phone history compensated for a lack of credit history. We also observed that a consumer’s behavioural characteristics such as knowing how many FAQs a consumer has read or the times of day at which they have applied for a loan was also correlated to credit performance. None of this information is available in today’s credit reports.

(2) Security vulnerability of centralized systems
As demonstrated by the recent Equifax breach in which the personal data of 145 million Americans is now at risk, the existing credit bureaus are plagued by cyber security vulnerabilities. In 2016, the cost of identity fraud to consumers was $16 billion worldwide, a 16% increase from 2015[1]. The credit reporting agencies have been the prime data source for criminals committing identity fraud. The vulnerability of having such sensitive personal information controlled by a central authority and within databases that need constant supervision and updating has repeatedly been shown to be a flawed and very costly solution. 

In the words of Senator Schatz, “The impact on Equifax’s impacted customers is potentially devastating. As a result, of identity theft and fraud, Equifax customers now face the risk of having debt accrued in their name. They could suffer long-lasting damage to their credit, and as a result, they could be denied loans, mortgages, employment or even rental housing”. 

Additionally, fraud has been committed by the credit reporting agencies themselves on consumers. In 2013, Equifax and TransUnion were fined $23.3 million by the CFPB for deceiving customers about the cost of their services. Services advertised as $1 were actually billed at $200 per year[2].

New technologies present an opportunity to address these flaws
As often is the case, the solution lies in the application of new technologies. Blockchain related technologies allow trust to be decentralised and thereby remove the need for central institutions to act as the trusted source of truth. Decentralization in turn brings with it security benefits. Rather than one corporation or database owning and controlling such sensitive information, decentralized system allows each user to store their own encrypted data securely and thereby removes the threat of a central attack affecting millions. Projects like IPFS, Pillar, Enigma and Blockstack are using blockchain’s architecture to enable user data to be siloed from server applications, thus making it infinitely more secure. The evolution of digital contracts, known as “smart contracts” enable systems built upon such technologies to self-regulate and perform. 

At Pave we experienced and suffered the flaws described in this article of the way consumer’s financial data is handled. We were subject to borrower fraud and lent to borrowers often with only a limited view of their financial profile. Our new product, the Global Credit Profile is an attempt to change the status quo. It’s a situation that the Big 3 are understandably not incentivised to change. We are moving ownership, control and access to financial data into the hands of the consumers while at the same time maintaining the data’s reliability. Through these new technologies, we will let consumers have better clarity on their own profile and allow them to share their data in a verified manner with those looking to offer them products or services. We’ll allow them to be rewarded for sharing their data and perhaps most importantly change the environment in which their data is stored to ensure its security.

Its our belief that these new technologies are the path towards global financial inclusion and better access to credit. 

About the author
Oren Bass, Pave’s CEO founded the company in 2012 with the mission to utilize technological innovation to democratize access to funding. Pave's innovative approach to lending enabled the company to successfully lend to more than 1600 individuals with "thin credit files" totalling close to $23 million in loans. In September 2017 Pave announced the introduction of a new product, the Global Credit Profile project – a blockchain based alternative to traditional credit bureaus. For more information see www.pave.com/gcp 

[1] www.cnbc.com/2017/02/01/consumers-lost-more-than-16b-to-fraud-and-identity-theft-last-year.html 7

[2] www.washingtonpost.com/news/get-there/wp/2017/01/04/equifax-transunion-fined-23-million-formisrepresenting-credit-products 10