Credit Bureaus: A repository of consumer credit information

From the very early days, lending institutions aspired to reduce much of the information asymmetry between individual borrowers and lenders in order to manage their portfolios. Credit scoring models, which were first used more than 50 years back, helped them achieve this objective.

These models used the information from a customer’s financial, as well as general, behaviour in the past to predict his/her creditworthiness in near future.

In the beginning, the scoring models were quite judgemental in their approach and depended significantly on credit officer’s discretion. The statistical techniques came into play much later when historical default data from the relevant population were used to build predictive models.

Different explanatory factors like occupation, job and leasing history, along with the amount and number of debts, frequency of payments and credit charge-offs were considered for model construction. The factors were simultaneously weighted through a statistical process to arrive at a definite credit score for an individual consumer. A higher credit score from the model could reward a customer with lower interest rates and favourable term lengths for a loan while a low score could make him/her ineligible for the same.

Statistical scoring models helped most of the credit institutions to achieve speedier, objective and consistent decision-making to manage their high transaction volumes. In some cases, a sophisticated system of score-based pricing was introduced to ensure a higher profitability for a consumer portfolio.

However, the accuracy of all of these models depended on availability of accurate customer data from various sources. The institutional need gave rise to demand for a repository of consumer credit information. Credit bureaus stepped in to bridge this gap. Although a relatively new concept in many of the GCC markets, these bureaus came up across developed regions like the United States and the United Kingdom as early as in the late 19th century.

Currently, major US credit bureaus like Equifax, Experian and Transunion continue to absorb billions of consumer records. On a regular basis, these bureaus source personal and financial information from various data furnishers like creditors, lenders, utilities, debt collection agencies and the courts (that is, public records) that a consumer has had a relationship or experience with.

Data furnishers also report their payment experience with the consumer to the credit bureaus. All of the collected data are then aggregated by the bureaus into data repository or files. It is then processed and credit scored via proprietary scoring models.

In exchange of a certain fee, the resulting information is then made available on request to customers of the credit bureau for the purposes of credit risk assessment, credit scoring or for other purposes such as employment consideration, insurance or leasing an apartment.

It is interesting to note that the data furnishers themselves along with the individual borrowers would be among the major consumers of this processed data from the bureaus. The usage of this scored data is the most among businesses which lend small sums of money to individual borrowers or even smaller industries. Given that the number of transactions here are very high, rule-based credit scores from the bureaus help them achieve an effective portfolio management apart from saving a great deal of time and cost.

Does the overall economy actually benefit due to the institution of credit bureaus? Absolutely yes! If we look deeper, we would find that various competing data furnishers collaborate and set up these credit bureaus initially to serve their own economic interests.

While many of the data furnishers have the ability to construct a credit score based on their own data, they still would not have the access to the borrowers profile across the market. This is critical information for small individual borrowers and often leads to a large unexplained component in the predictive power of standalone scoring models.

The phenomenon incentivises even the most sophisticated institutions to share data and help the foundation of the credit bureau institution. The bureaus act as an intermediary to ensure that the information asymmetry in the overall lending system is minimised by collating data across different sources.

As more and more large and small institutions get connected to these bureaus and continue to supply accurate data, it creates a virtuous cycle of value addition to the economic system in general. It helps to grow the financial prudence of the society as record holders of bad debt get increasingly punished and excluded from the system.

On the contrary, the best customers get rewarded with the best loan terms. Credit bureaus essentially act as an information banking intermediary helping the entire lending system to achieve accurate price points for various risks underwritten. Financial stability of the entire ecosystem is enhanced.

Lending efficiencies increase as bid-offer spreads diminish on the back of increased transparency of borrower information. All in all, credit bureaus turn out to be a major hallmark of development for any modern financial market.

How many credit bureaus do we need for a country?

In terms of the number of bureaus, while it may be worthwhile to have a few competing credit bureaus, too many of them could have a negative impact on the network benefits. Most often, a balance should be struck to ensure that an optimal number of credit bureaus operate within a country.

What are some of the challenges for a credit bureau’s operation?

Given the sensitivity of the enormous amount of confidential data which the bureau handles, it has to exercise immense caution in the protection and management of the same. Any leakage or inappropriate marketing of the data could pose serious doubts on the credit bureaus standing. Additionally, any inaccurate credit scoring or discriminatory models linked to race, sex or marital status can be challenged severely by rights activists. A fair and equitable practice of credit scoring should be encouraged in these bureaus where the borrowers themselves would also have the rights to challenge his/her score and make an appeal for an independent review process, if required.

In 2014, the UAE approved by-laws for the creation of a nationwide credit bureau, which is a step in the right direction for the development of its lending market. However, the true benefits of the bureau will be felt only when the input credit data starts to flow methodically into the bureau and the processed information is then used by the institutions to effectively manage their lending portfolios.

— The author is a risk manager with an MNC bank in the GCC region. The views expressed are his own.