Will COVID mean the end of credit scores?
Credit scores are proving unreliable in the COVID economy, forcing skittish banks to turn off the consumer credit spigot. Cash flow scoring can break the lending logjam and expand access to credit.
This summer, The Wall Street Journal’s front page displayed a stunning headline: “banks can’t tell who’s creditworthy”. The story noted that during the COVID crisis, banks have been forced to significantly scale back consumer lending, making it much tougher to qualify for new credit cards or for personal and auto loans.
Why? Because the tool that banks have relied on for more than 50 years to assess people’s creditworthiness — the credit score — is proving unreliable in the COVID economy. That has left many banks “Flying Blind Into a Credit Storm”, as the WSJ headline put it, and as a result, they have turned off the credit spigot. This means that credit is now harder to obtain, at a time when many people need it most.
Our experience at Petal tells us it doesn’t have to be that way. During this crisis, we have leveraged an alternative approach — cash flow scoring — to overcome the inherent limitations of credit scoring and help more people access credit in an environment where many banks and other lenders have gone missing.
Credit scores have always had limitations. For starters, they don’t capture many aspects of people’s finances — income, for example — that are important to fully understand how someone is faring financially. As many as 20% of credit reports contain material errors. And many Americans are missing credit scores entirely.
But the COVID crisis has exposed an even bigger structural problem: credit scores don’t measure the present; they measure the past. And in a volatile and rapidly-changing economy, that’s a major blind spot for anyone seeking to lend money.
In a severe economic downturn, people’s financial situations can change — indeed, have changed — dramatically in a matter of days. But the financial decisions they make now — good or bad — won’t show up on their credit reports for months. People who are on the edge financially may look perfectly fine on paper. Lenders have no way of knowing how those applicants are doing financially today.
The pandemic has made things even murkier. There are many, many signs that we are in the midst of a financial crisis of truly historic proportions. Yet months into that crisis, many of the traditional inputs into credit scores look deceptively positive.
TransUnion and Experian data show consumer credit scores are actually going *up*, during the sharpest economic contraction in modern history.
People are paying down more of their credit card debt; the Federal Reserve Bank of New York recently reported that in the second quarter, total credit card debt declined by a staggering $82 billion, the largest such decrease in 20 years. Americans are utilizing a much smaller percentage of their available credit than at any point since the last financial crisis. And they’re making fewer late payments (as much as one-third less, according to Equifax).
These positive signals are boosting credit scores through the crisis, potentially upending decades of industry beliefs about the components of creditworthiness. How can credit scores be improving while tens of millions are out of work…?
The head-scratching gulf between credit scores and the dire state of the economy is a real problem for our financial system. We know the patient is very, very ill, but the traditional measures of health seem to indicate things are fine.
Financial relief programs like the CARES Act have confused the credit scoring system by masking the economic reality on the ground.
The CARES Act provided tens of millions of Americans with unemployment assistance and stimulus payments, offered forbearance protections for student loan and mortgage payments, and introduced new programs designed to temporarily retain small businesses jobs. The CARES Act also included provisions that restrict creditors from reporting adverse credit information for customers impacted by the COVID crisis. In addition, private relief programs offered by lenders, mortgage companies and other creditors have allowed consumers to defer and modify their payment obligations.
These programs have given Americans more flexibility and a temporary influx of income that has allowed them — for now — to meet their financial obligations. But the programs are temporary, and have skewed the fundamental data that the financial industry relies on to assess who is creditworthy.
In today’s environment, credit scores may bear little resemblance to consumers’ true financial picture. Though a consumer’s credit report may show a history of on-time payments, lenders can only guess as to whether that person has been impacted more deeply by the economic meltdown. Are consumers paying down debt because they’re in a position of financial confidence and strength, or because they have cash on-hand now and are worried they won’t have the income to make payments in the future?
A credit report can’t answer those questions. But cash flow scoring can.
If lenders can’t tell the difference between customers on strong economic footing and customers on the edge of financial collapse, the safest decision is to slow — or even stop — lending. Data shows that’s exactly what has happened; over the past six months, there has been a significant clamp-down in banks’ willingness to extend credit to customers.
As a result, people who would have qualified for credit before the pandemic are now being turned down. In a very real sense, these consumers are paying the price for many banks’ reliance on credit scores.
Cash flow scoring can break this lending logjam, by giving lenders real-time insights that credit scoring alone can’t deliver. Cash flow scoring is simply an analysis of creditworthiness based on a consumer’s recent banking history. It measures economic fundamentals that don’t show up in traditional credit reports, like people’s income and employment status, the bills they pay each month, and the amount they’re saving. Cash flow data also reflects sudden changes in income, whether it’s the stoppage of paychecks or the receipt of stimulus payments or unemployment checks.
Together, these insights can give lenders clarity and certainty about a consumer’s true financial position, even in a turbulent and uncertain economy. That clarity would enable lenders to extend credit to more people, with less risk, on terms tailored to each person’s financial situation. Cash flow scoring technology delivers certainty in uncertain times.
This isn’t just theoretical. Insights from cash flow scoring have enabled Petal to continue making credit accessible in today’s volatile market conditions, even to people who don’t yet have a credit history. In a time when banks and major issuers are pulling back in consumer credit, we’re interested in acquiring as many new customers as possible.
COVID has accelerated many technology trends already in the works prior to the pandemic, from ecommerce and remote work to digital banking. Let’s hope — for the good of consumers and our financial system — that it has the same modernizing effect on the credit scoring system.
Petal Card issued by WebBank, Member FDIC.
Thanks to Matt Graves and Mayank Verma.
