Bankers' Catch-22: Lending to People Lacking Credit Histories

SMITH BRAIN TRUST -- Borrowers live or die by their FICO scores — numbers that offer a snapshot of how reliable they've been in paying back their debts. But some 53 million Americans don't have such scores because their credit history is thin or nonexistent. Now the Fair Isaac Corporation (aka FICO), is testing a new measure that would open up credit to many of these people by analyzing how faithfully they've paid their cable and utility bills, as well as how often they've moved.

This means some financially responsible people will get their feet into the door of banks for the first time. Yet it also could expose banks to fresh sources of risk.

Cliff Rossi, a professor of the practice at the Smith School with 25 years of experience at some of the largest financial-services companies, and in government, calls this new FICO sore "somewhat of a holy grail" for bankers. They have long known that some segment of the population with thin or non-existent credit histories are likely to be responsible borrowers. 

What has been lacking is not information but a reliable and convenient tool with which to evaluate it, says Rossi. Borrowers may state in their application that they have been reliable payers of utility bills and rent, but banks have lacked the time, and the right algorithms, to sort through that data.

Paradoxically, people who don't believe in borrowing money unless absolutely necessary, for prudential or even moral reasons, find it difficult to get a loan when they finally do need one, no matter how financially responsible they have been. The new credit score would help eliminate that Catch-22.

Some companies, notably VantageScore, have experimented with alternative credit scores, but the involvement of the ubiquitous FICO is likely to make them more credible.

To be sure, Realtors and lenders have been pushing for a development like this not out of altruism but so they so they can sell more houses and make more loans of every kind. That kind of pressure has led to trouble before. "As we are talking about non-traditional credit," Rossi says, "we should also think of ways to make good educational tools to help people make good decisions."

"Financial counseling is vitally important for this kind of borrower. If they have counseling on the use of credit, that has been shown to have significant value."

Siva Viswanathan, an associate professor at Smith, says that the new score should help to reduce what sociologists call the "Matthew effect": the tendency of the rich to get richer while the poor get poorer. Credit scores create an artificially stark line between people with a credit history and without it—"haves" and "have-nots." "There is no reason to think that all have-nots are bad. They may be new entrants into the credit market—students just getting into the job market, or immigrants just arriving in the country," Viswanathan says.

The new FICO score is a step forward but remains fairly conservative, he says, because it relies on hard data like bill payments. Meanwhile, technology is making soft data, including the language that borrowers use and the sorts of people they associate with, more quantifiable.

For example, Viswanathan's research has shown that the words that borrowers deploy in their loan applications can be used to predict default rates: Positive, optimistic terms are associated with lower default rates.

And social media offers another rich source of information. "If you have a lot of defaulters in your social network, what we have found is that you are more likely to default," Viswanathan says. "You can see how default, like the flu, can be socially contagious."

Such soft information can help lenders make better decisions whether or not people already have FICO scores—at some cost, it goes without saying, to their privacy.

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