Suppose your brother wants to borrow $1,000 from you to buy a new stove and refrigerator. How do you know he’ll pay you back? Since you grew up with him, you have a good idea how financially secure he is and how good he is on living up to his promises.
Suppose it’s not your brother who wants to borrow that $1,000 but a friend from church. You know a little less about him, but since you see him often and run in the same circle of friends, you still have some idea whether he’s trustworthy or not.
How about a co-worker or your child’s third-grade teacher or a someone who just moved into town six months ago? As the social distance becomes longer, you have less information and fewer social cues to rely on to determine if the borrower will pay the loan back.
Take this one step further. Say you live in Chicago and a stranger from Phoenix asks you for a $1,000 loan. How do you know this person is a good risk? You have no idea. That’s the problem financial services companies face every day.
Until the mid-1960s, companies relied on loan officers to use their individual judgments in determining creditworthiness and one-size-fits-all interest rates that treated low-risk borrowers the same as higher-risk ones. But this couldn’t scale with a growing economy of consumers hungry to buy new cars and household goods on credit.
In response, innovators began collecting credit and financial data and developing statistical models to determine individuals’ levels of risk. These credit scores allowed consumer lenders to tailor lending prices (interest rates) to individual risk profiles. A lender could now extend credit to both low-risk and high-risk customers.
Risk-based pricing first appeared with credit cards. It then expanded to auto loans and mortgages. Today, keeping an eye on one's FICO score is a ritual for many Americans.
A report for the U.S. Chamber’s Center for Capital Markets Competitiveness finds that these tools--risk-based pricing and credit scoring--lower the cost of consumer credit for most borrowers and expand credit access. Professor Michael Staten, Endowed Chair and Director of the Take Charge America Institute at the University of Arizona, notes four key features of these innovations: Fairness; Financial Inclusion; Innovation; and Economic Growth.
Because of risk-based pricing, consumers’ access to credit and financial services doesn’t depend on social connections or the reputation of their family’s name. Instead, objective data of an individual's financial situation and payment history expressed as a credit score is used to determine a consumer’s credit risk and interest rate. This “increased the consistency of a creditor’s lending decisions and the likelihood of equal treatment across tens of thousands of applicants,” Staten writes. In addition, it's lead to lower costs:
Compared to a one-price-fits-all system, a borrower in a market characterized by risk-based pricing is less likely to be paying for the costs imposed by someone else’s behavior. Interest rates on loans to low-risk borrowers can be lower because they do not have to cover the costs imposed by higher-risk borrowers who have more difficulty making their payments.
What’s more, risk-based pricing rewards consumers’ good credit behavior. A history of timely payments and an improved financial situation will be reflected in an improved credit score.
2. Financial Inclusion
With the ability to tailor prices, lenders can extend credit to more consumers. “Rather than reject applicants who posed default risk of, say 5% or even 10%, creditors could accept them and charge an appropriately higher price for the loan to cover the extra risk,” writes Staten. A 2007 Federal Reserve report that found that “risk-based pricing expands access to credit for previously credit-constrained populations, as creditors are better able to evaluate credit risk, and, by pricing it appropriately, offer credit to higher-risk individuals.” This has extened consumer credit to millions of Americans across the economic spectrum:
Between the early 1980s and 2001, consumers in the lower half of the income distribution experienced 200-300% increases in the percentage of households with access to general purpose credit cards, and 30-70% increases in access to other types of consumer loans.
Lending companies are in the business of loaning money to those who can pay it back, and they’re competing with other companies for these consumers. Improved data analysis, statistical modeling, and risk-based pricing becomes a competitive edge. “One of the virtues of scoring as a decision assistance tool is that new data improves the ability of these models to fine tune a lender's assessment of risk, Staten writes. As more data is processed and credit scoring tools are improved, risk-based pricing leads to expanded credit access:
An excellent example is the recent inclusion of alternative consumer payment data from apartment rentals and utility payments. Incorporating these data into scoring and loan pricing is dramatically expanding credit availability to 30-55 million American consumers who were previously under-served by conventional loan markets. Rather than shutting these individuals out of the market, scoring and risk-based pricing have given lenders the tools and incentives they need to say “yes” to loan applications from a far wider cross-section of the population than ever before.
4. Economic Growth
This expansion of consumer credit access through risk-based pricing gives the U.S. an economic growth advantage, Staten finds:
Credit markets that make loans accessible to large segments of the population provide a cushion that neutralizes the macroeconomic drag associated with temporary declines in income, lowering the risk of outright recession and reducing the magnitude of downturns when they do occur.
Well-developed consumer loan markets also give consumers greater mobility. There is less risk associated with severing old relationships and starting new ones hundreds or thousands of miles away because objective information is available that helps U.S. residents to establish and build trust in new locations more quickly. From a labor market perspective, the ability of lenders to tap and utilize the detailed information in our credit reporting system has increased the mobility of the U.S. population. As a result, structural shifts within the economy can cause temporary employment disruptions without crippling long-term effects.
However, Staten warns that regulations that limit the use of credit scores and risk-based pricing will mean less access to credit for higher risk consumers and higher costs and less innovation:
Regulation that would limit the use of either credit report information or the various scoring and pricing tools that have been built with that data, or invoke doctrines like disparate impact that implicitly challenge the use of objective criteria in lending and pricing, would stifle innovation, reduce the potential for improved models to bring their enormous benefits to consumers across the credit spectrum, and roll back many of the benefits already obtained.