> Posted by Mr. Provocative
Even in the U.S. there is no set standard for calculating credit scores
Joe Nocera, a business columnist for the New York Times, recently published a piece about the frequency of unreliable credit scores. His experience should give the microfinance industry pause as it rushes to embrace the creation of credit bureaus.
Some microfinance practitioners want to move away from the traditional, high-touch (very imperfect) loan-officer evaluation of client creditworthiness to the use of information gleaned from credit bureaus as a key to managing portfolio risk. And ultimately it is hoped that more complete credit reports will create greater operational efficiency, allowing interest rates to drop. Furthermore credit bureaus will help protect against the growing plague of undetected multiple borrowings that hurt an MFI’s bottom line and allow clients to fall into over-indebtedness.
As David Roodman of the Center for Global Development argues in a June 1, 2010 interview on NextBillion.net, “Where credit bureaus are practical, they are definitely good things to create. It makes perfect sense that lenders need complete information about how much borrowers really owe.”
Yes, in a world where human beings can be counted on to input accurate, complete and up to date data. But what are the consequences for clients if this is unrealistic, even Pollyannaish thinking?
Mr. Nocera, evaluating the US experience with credit bureaus, emphasizes the unreliability of credit reports,
“There are people with low credit scores who are quite creditworthy. There are people with high scores who aren’t. Treating credit scores as if they were infallible—which is what the banking industry is now doing—is beyond foolish…. You would think, given the critical importance of an accurate score, that there would be rules about the information that is submitted to them. There aren’t. Lenders can submit information about your credit history to one of the bureaus, all of them or none of them. Some of them turn over information right away; some take months; some don’t do it at all. Some are sticklers for accuracy; others are sloppy. The point is that the credit score is derived after an information-gathering process that is anything but rigorous.”
On examining his own personal credit reports from the major credit bureaus, Nocera discovered they were rife with inaccuracies. “According to Experian, I was still writing for Fortune magazine. It said I no longer lived in a house that I just bought two months ago. TransUnion, meanwhile, listed The New York Times as my former employer. Currently, TransUnion said, I am an employee of Rite Aid.”
With the credit bureaus in the United States quite prey to error after years of presumably perfecting their methodology, what makes us think that establishing credit bureaus in the developing world will produce superior results?
It behooves all of us in the microfinance industry to make sure that these bureaus in the developing world don’t follow the example of their giant (presumably far more sophisticated) counterparts in the United States. Or the poor clients of MFIs will grievously suffer and their trust in the banking sector will erode. These starts-up operations require rigorous oversight and monitoring from day one.
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September 28, 2010 at 7:52 pm
Ros Grady
The answer to these cautionary points from Mr. Provocative is not to deny the developing world all the well-documented benefits of credit bureaus. See, for example, the work of the International Finance Conference’s Global Credit Bureau Program: http://www.ifc.org/ifcext/gfm.nsf/Content/FinancialInfrastructure-GCBP-News.
Instead lets be smart about the design of the consumer protection regime that applies in this context. For example, we might have provisions dealing with the following issues: a “reasonable” steps obligation to ensure that information on a credit file is accurate and up to date, advance notice if information is to be given to a credit bureau, rights of access and correction, notice if a credit application is refused on the basis of an adverse credit report, identity theft, dispute resolution and permissible uses and disclosures of information held by a credit bureau. There are, of course, many other facets of a well-designed credit bureau regime, but these issues should be considered in any design.
September 29, 2010 at 4:39 pm
Sergio Guzmán
Perhaps it is also an opportunity to highlight two Client Protection Principles that we consider that are directly relevant to Credit Bureaus:
1. Preventing Over-indebtedness
2. Privacy of Client Data
In preventing over-indebtedness, one of our key indicators is:
The loan approval process requires evaluation of borrower repayment capacity and loan affordability. Loan approval does not rely solely on guarantees (whether peer guarantees, co-signers or collateral) as a substitute for good capacity analysis.
And another one is:
When available, the financial institution checks a Credit Registry or Credit Bureau for borrower current debt levels and repayment history. When not available, the financial institution maintains and checks internal records and consults with competitors for same.
Essentially institutions can benefit from Credit Scores by getting a fuller picture of the client’s indebtedness by knowing if a client has a timely payment record or even if the individual has more than one current obligation. Clients in turn benefit because having a credit history will help them prove their credit-worthiness in the future. Not having a database where institutions can verify a client’s total debt can distort a credit decision, providing a client with an inadequate amount or simply one that they cannot afford to repay. In our Smart Assessment we are careful to see what role the Credit Score plays in determining the approval or not of the loan. We have seen two things: 1) Credit scores serve as a pre-analysis, if clients turn out with negative histories on their credit a more nuanced look at their cash flow is needed from the loan officer, who will have to defend the loan decision before a credit committee. 2) Credit histories are a preliminary screening for clients, if clients have negative credit reviews, forget about getting a new loan (this is to prevent PAR contagion or debt spiral by clients).
The other point that you mention, regarding the erosion of trust between MFIs and their clients, with Credit Bureaus being at the center of this controversy can be addressed though the following indicator from principle 6, Privacy of Client Data:
Clients know how their information will be used. Staff explains how data will be used and seeks permission for use.
MFIs need to explain to their clients the importance of credit bureaus, why they matter and why they can benefit them in the future. If clients know what information is going to be used and MFIs provide explicit information about how it is used, then clients feel more comfortable sharing information with the Credit Bureaus and they don’t have to scavenge the information from different places, which would probably create a blurry image (like the one Mr. Nocera refers to).
Just a couple of thoughts.
September 30, 2010 at 7:34 am
Fehmeen | Microfinance Hub
Agreed, credit bureaus can be lethal if credit profiles contain incorrect information (reported ratings are inflated/deflated by mistake) but the level of information leaders want credit bureaus to store about microfinance clients is pretty basic – the main concern being the amount of outstanding debt that a client has at any given time. That’s hardly a big task on its own.
October 25, 2010 at 10:47 am
Camilo Blanco
The point is that every credit evaluation should include all the information that is available to the lender, we know that there are imperfections in the information and this is totally in line with the principles explained by Eugene Fama in the second half of the 20th century, which explain the different levels of information relaibility and its relation to market efficiency. I know that credit bureaus sometimes are quite sloppy, but the responsability from the MFI is to perform the evaluation according to their methodology, incorporating the decision elements that allows them to make a good decision, it is not good to rely only on one tool, not even on the principles of efficiency since this normally leads to bad credit decisions inside the institutions and substandard performance in the credit process, as Mr Guzman said, the idea is to prevent over indebtness, and this kind of processes normally ends in clients who are not able to pay their dues.
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