Credit scoring is broken. Open Banking can help fix it.
At Credit Data Research, we believe that open banking and PSD2 are going to reshape the way small and medium sized businesses (SMEs) access credit. Existing models of credit scoring aren’t fit for purpose and new fintech innovations have added complexity rather than clarity. But real-time access to credit information — which open banking and PSD2 enable — will transform the SME lending market.
What’s wrong with SME lending at present?
Following the 2007/8 financial crisis, SMEs have experienced a drastic reduction in their access to credit and financial intermediaries have suffered losses on their SME lending portfolios. Existing risk assessment systems have reinforced, rather than help to solve, this impasse. Scoring systems typically use data that reflect the businesses financial performance 15–18 months ago. Cash flow crises, one of the major causes of default among SMEs, can originate in just 2–3 months, causing the closure of businesses considered financially stable for decades. In cases like this, balance sheet information, by definition, can’t capture the credit event. This lack of updated information makes it hard to identify the drivers of credit stability.
A number of fintech startups tried to improve SME credit scoring using non-traditional datasets and new data analysis techniques. However, discovering that an SME’s credit risk is correlated to its ranking on a search engine, or the number of mentions in the social media, together with other n-hundreds factors, does not lead to accuracy but rather over-complexity and errors.
What will make it better?
Getting credit scoring right is in essence a matter of accessing the right data at the right time. Knowing, in real time, how a company utilised its accounts, credits and payments is far more efficient, intuitive and predictive than taking into consideration hundreds of other variables.
PSD2 is a positive step in this respect, allowing:
- real time access to credit information; and
- third party access to granular banking data.
These two developments will improve the quality of SME credit scoring and enable new entrants to spread innovations through the market much quicker than has traditionally been the case in banking.
What does this look like in practice?
Credit Data Research will be bringing ‘The Credit Passport’, an innovation we developed in Italy, to the UK. The Passport combines the SME’s company data (such as their most recent balance sheet) with their bank account transaction data and credit registry data. Using technology from Moody’s Analytics, we compile a Passport report that can be accessed by the SME so they better understand the way banks are analysing their credit profiles. We’ve found that SMEs, as well as using the Passport to improve their internal credit culture, have also started presenting it to suppliers to get better commercial conditions.
Banks, alternative lenders and event investment banks are also using The Credit Passport. Banks are providing Credit Passports to their SME clients, recognising that a company that is financially aware of its credit risk is a less risky company. Meanwhile, alternative lenders have outsourced their risk engine to Credit Data Research, allowing them to focus on what they do best: reinventing the user experience for borrowers. Finally, Credit Passport is used by investment banks in order to add more transparency to the collateral pool of a structured transaction. With our Credit Passport, arrangers are able to price the risk appropriately, whereas investors have the required transparency to buy SMEs backed securities and monitor the collateral basket.
Alessio Balduini is CEO of Credit Data Research.