Partners (Number 3, 2007)
Partners (Number 3, 2007)Report to the Congress on Credit Scoring and Its Effects on the Availability and Affordability of Credit
The following is an excerpt from the Federal Reserve Board's report to Congress on the effect of credit scoring on credit. This overview of the report provides background on credit history technologies and the scope of the Board's analysis.
In recent decades, consumer credit markets in the United States have become increasingly national in scope as lenders have been better able to expand their geographic reach. These trends have been facilitated by the development of statistically derived credit-scoring models to evaluate credit risk mechanically, help establish loan prices, and manage consumer credit accounts. As a cost-saving technology, credit scoring has greatly affected consumer credit markets by allowing creditors to gauge credit risk more inexpensively and readily and expand their reach to consumers beyond the limits of their local offices.
The data maintained by credit-reporting agencies on the credit-related experiences of the majority of adults in the United States are at the heart of most credit-scoring models.1 Although credit scoring has been a feature of consumer lending markets for some time, its role has expanded in recent years, in part because the data maintained by those agencies have become more comprehensive. Indeed, many credit-scoring models, particularly those used for screening users of unsecured revolving consumer credit, such as credit card customers, are now sometimes based entirely on information contained in the records of the credit-reporting agencies. The scores generated by those models, referred to here as credit history scoring models, have helped to reduce substantially the cost and time needed to make credit decisions and to identify prospects for new credit.2
The evaluation of creditworthiness, whether based on judgment or based on a credit score, is an inherently inexact science in that it attempts to predict the future: whether a loan will be repaid according to the agreed-upon terms. In building a credit-scoring model, the goal is to identify and use only those factors that have a proven relationship to borrower payment performance. By law and regulation, an individual's personal characteristics—such as race or ethnicity, national origin, sex, and, to a limited extent, age—must be excluded from credit-scoring models. In this way, credit scoring promotes consistency and objectivity in credit evaluation and may help diminish the possibility that such personal characteristics are considered in the lending process.
As the use of credit scoring has expanded, so have concerns about the extent to which it may affect access to credit and about whether scoring may have adverse effects on certain populations, particularly minorities or those that rely more heavily on nontraditional sources of credit. These concerns reflect, among other things, a belief that the effect of including certain credit-record items in the development of credit-scoring models may have a differential effect on certain groups, particularly on racial and ethnic minority groups relative to non-Hispanic whites.
Little research has been conducted on the potential effects of credit scoring on minorities or other groups. Reliable data for conducting such research are not readily available. Creditors are generally prohibited from collecting race, ethnicity, and other personal demographic information on applications for credit, except in the case of mortgage credit. Even in the context of mortgage credit, only limited information is collected.3 Consequently, with the exception of dates of birth, the credit records maintained by the credit-reporting agencies do not include any personal demographic information.
The Fair and Accurate Credit Transactions Act of 2003 (Fact Act) addressed the need for research in this area.4 Section 215 of the Fact Act directed the Federal Reserve Board and the Federal Trade Commission (FTC), in consultation with the Office of Fair Housing and Equal Opportunity of the Department of Housing and Urban Development (HUD), to study:
- the effects of the use of credit scoring on the availability and affordability of credit;
- the statistical relationship between credit scores and the quantifiable risks and actual losses experienced by businesses after accounting for personal demographics and other known risk factors;
- the extent to which the use of credit scores and credit-scoring models may affect the availability and affordability of credit to protected populations under the Equal Credit Opportunity Act (ECOA);
- the extent to which the consideration or lack of consideration of certain factors by credit-scoring systems could result in negative or differential treatment of protected classes under ECOA;
- the extent to which alternative factors could be used in credit scoring to achieve comparable results with less negative effect on protected populations;
- the extent to which credit-scoring systems are used by businesses, the factors considered by such systems, and the effects of variables that are not considered by such systems.
Section 215 also directed the study to include an analysis of these same questions for the use of credit scoring in insurance markets. In preparing the study, the Federal Reserve took the lead in assessing the effects of credit scoring on credit markets; the FTC took the lead in the area of insurance and is preparing a separate report on this subject. The present document focuses on credit scoring and credit markets.
Scope of the analysis
Section 215 of the Fact Act essentially asks for four related analyses regarding the use of credit scoring in credit markets. The first is an analysis of the effect of credit scoring on the availability and affordability of financial products to consumers in general. The second is an analysis of the empirical relationship between credit scores and actual losses experienced by lenders. The third is an evaluation of the effect of scores on the availability and affordability of credit to specific population groups. The fourth is an evaluation of whether credit scoring in general, and the factors included in credit-scoring models in particular, may result in negative or differential effects on specific subpopulations and, if so, whether such effects could be mitigated by changes in the model development process.
Different approaches were taken to conduct each of these four analyses. The approach used to assess the general effect of credit scoring on the availability and affordability of credit was to rely on evidence from public comments, including those from government agencies, industry representatives, community organizations, and fair lending and fair housing organizations. The analysis also drew on evidence from previous studies on the topic and from indirect evidence obtained from an analysis of the Federal Reserve Board's Survey of Consumer Finances.
To examine the empirical relationship between credit scores and actual losses experienced by lenders and to examine the effect of scores on the availability and affordability of credit to specific population groups, the study relied on a nationally representative sample of individuals drawn from credit-reporting agency files at two points in time. Importantly, we were able to obtain information on race, ethnicity, sex, and other demographics from the Social Security Administration (SSA) that could be matched to the credit-record data. Such demographic data have not been available for previous research on credit scoring. The data set also included two commercially available generic credit history scores. In part because of the important role they play in credit markets and in part because of data issues, the analysis in this report focuses on generic credit history scores.
The data assembled here were also used to estimate a credit history scoring model emulating the process used by industry model developers. This model was used to investigate whether the factors included in credit-scoring models result in negative or differential effects on specific subpopulations and, if so, whether such effects could be mitigated by changes in the model development process.
Before the introduction of credit scoring, the evaluation of creditworthiness was conducted manually and judgmentally by loan officers relying primarily on experience and subjective assessments of credit risk. Because loan officers differ in their experience and subjective assessments of different credit-risk factors, underwriting based on judgment can be inconsistent and difficult to manage. Moreover, manual credit evaluation is time consuming and thus costly.
Both credit scoring and underwriting based on judgment tend to be opaque processes. In the case of credit-scoring models, they are proprietary, and firms that develop them typically provide the public with only general information about how they were created and how well they perform. In the case of underwriting based on judgment, methods are not likely consistent, even within a firm, because evaluators differ in their experience and judgment about credit risk and because it is difficult to establish clear guidelines that would address the numerous factual differences in the credit profiles of consumers.
After a period of rather slow acceptance, credit scoring had, by the 1970s, become widely used by most national lenders. Subsequently, the use of credit scoring expanded greatly with the development of generic credit history scores by Fair Isaac Corporation (FICO scores) and by Management Decisions Systems (the MDS Bankruptcy Score) in the 1980s. Some time after the introduction of these scores, the three national credit-reporting agencies (Equifax, Experian, and TransUnion) developed their own proprietary generic credit history scores, and recently the three agencies jointly developed a new generic credit history score named the VantageScore.5 Credit scores derived from each of these models are marketed to lenders, and together they have become an important tool not only for credit evaluation but also for the prescreening and solicitation of new customers.
The effects of credit scores on the availability
and affordability of financial products
Although many of the broad effects of credit scoring are well understood, quantifying the effects of credit scoring on the availability and affordability of credit is difficult. The available evidence comes from three sources: comments received from the public on this study and previous research, original analysis of credit records obtained for this study, and an assessment of consumer survey data. Little specific evidence on these topics was provided in public comments or is available from earlier studies.
The available evidence indicates that the introduction of credit-scoring systems has increased the share of applications that are approved for credit, reduced the costs of underwriting and soliciting new credit, and increased the speed of decision making. It has also made it possible for creditors to solicit readily the business of their competitors. Although credit-scoring systems can be expensive to develop, they can be operated at low marginal cost. To the extent that the lower costs and time savings are passed through to consumers, they will lead to lower interest rates and greater access to credit.
Credit scoring also increases the consistency and objectivity of credit evaluation and thus may diminish the possibility that credit decisions will be influenced by personal characteristics or other factors prohibited by law, including race or ethnicity. In addition, quicker decision making also promotes increased competition because, by receiving information on a timelier basis, consumers can more easily shop for credit. Finally, credit scoring is accurate; that is, individuals with lower (worse) credit scores are more likely to default on their loans than individuals with higher (better) scores.
Credit scoring increases the efficiency of consumer credit markets by helping creditors establish prices that are more consistent with the risks and costs inherent in extending credit. Risk-based pricing reduces cross-subsidization among borrowers posing different credit risks and sends a more accurate price signal to each consumer. Reducing cross-subsidization can discourage excessive borrowing by risky customers while helping to ensure that less risky customers are not discouraged from borrowing as much as their circumstances warrant. Finally, 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.
By providing a low-cost, accurate, and standardized metric of credit risk for a pool of loans, credit scoring has broadened creditors' access to capital markets, reduced funding costs, and strengthened public and private scrutiny of lending activities. To better understand the potential effects of credit scoring on the availability and affordability of credit, data from the Survey of Consumer Finances were used to examine how the use of credit has changed from 1983 (the first year for which the survey results are comparable with those of later years) to 2004 (the most recent survey year). During this time, the first generic credit history models were introduced, so it is an appropriate period in which to assess at least some of the effects of credit scoring. However, such an analysis of credit use can provide only indirect evidence of the possible effects of credit scoring on access to credit. Moreover, other factors, including changes in the economic and demographic circumstances of households, technological innovations, and financial deregulation also have affected access to credit, making it difficult to distinguish the effects of credit scoring.
The survey data show that the share of families with any debt rose for nearly all populations; the steepest growth was in the ownership of bank-type or travel and entertainment cards. These trends are in broad alignment with the conjecture that credit scoring has helped increase the availability of credit since the early 1980s. It is difficult to draw a strong inference regarding changes in differences in credit use by race or ethnicity, age and income. On the whole, the data do not provide clear and compelling evidence that the broader adoption of credit scoring disproportionately benefited populations that historically had lower rates of debt ownership; for the most part, differences in credit use across groups appear to have changed only slightly or even to have widened.
1Under the Fair Credit Reporting Act, these organizations are referred to as consumer-reporting agencies. Although these agencies are sometimes elsewhere referred to as credit bureaus, that term includes firms that do not collect information on credit accounts, and such firms are not considered in this report.
3 Under the Home Mortgage Disclosure Act of 1975, as amended in 1989, covered lenders are required to collect and disclose information about the race or ethnicity and sex of individuals applying for mortgages covered by the law.