United States: Credit Scoring In The Twenty-First Century

Last Updated: November 12 2013
Article by John E. Bowman

Tara Sugiyama Potashnik, an associate with Venable LLP, provided assistance with this Paper.

Observations from a Former Financial Regulator on the Need for Diversity and Innovation in the Provision of Third-Party Credit Scores


During the years leading to the Financial Crisis of 2008 and its fallout, I was uniquely positioned to observe (and in some cases, respond to) the unfolding of the many challenges that the crisis presented. At the height of this tumultuous period, I was serving as the Chief Counsel, and later as the Acting Director, of the Office of Thrift Supervision (OTS). Additionally, I served as a board member of the Federal Deposit Insurance Corporation (FDIC) and NeighborWorks America, as well as a member of the Federal Financial Institutions Examination Council (FFIEC). Prior to that time, I had also dedicated much of my career to government finance and the financial services sector, serving as a senior career employee focusing on financial institutions and financial matters with the U.S. Treasury Department. Since I left government, I have been working for financial services companies including those that rely on data and analytics to assess consumer and small business creditworthiness.

Having just passed the one year anniversary of my departure from government service, and having entered into private practice as a partner in Venable LLP's Financial Services Group, I have now had time to reflect upon the confluence of factors that may have contributed (perhaps unwittingly) to this financial maelstrom. Among such factors that I observed as a former financial regulator was the risk to regulators, lenders, consumers, and the economy as a whole, presented by a financial system that has come to over-rely on third-party credit scores provided by a single entity and the limitations inherent in that system. Credit scores have become integral to the consumer financial marketplace in this country, often serving a gatekeeping function and critical factor in whether lenders, acting under guidelines and regulations issued by themselves and their financial regulators, extend loans and other forms of consumer credit (e.g., mortgages, student loans, auto loans, credit cards) and what the terms of such credit might include. The well-being of the U.S. economy very much depends on the ability of consumers to spend, (which is in turn tied to their access to and cost of consumer credit), and the ability of lenders to lend in a safe and sound manner.

Such a system in which one entity has become ensconced as the dominant provider of third-party credit scores developed organically with the expansion in recent decades of the consumer credit markets in the United States. This expansion was aided by the development of cost-saving credit-scoring models that were designed to evaluate credit risk mechanically, establish loan prices, and manage consumers' credit accounts. In the twentieth century, such models were produced in the early days almost entirely by one entity, and that entity became synonymous with the term "credit score," much like how the term "Xerox®" has improperly become interchangeable with the term "copy" in everyday parlance. While a few other entities have provided third-party credit scores over the years, one entity has become by far the dominant provider of such scores, and is the beneficiary of the unintentional endorsement by regulators described in Section II of this Paper.

For purposes of this Paper, I have adopted the definition of "operational risk," as stated by my former colleague from the FDIC Board of Directors, Comptroller of the Currency Thomas Curry who explains that "operational risk" involves the "risk of loss due to failures of people, processes, systems, and external events." Operational risks for lenders and those they serve are created when any system relies on one entity to provide a key component to function, and this risk is particularly pronounced in the consumer credit marketplace. For example, lenders would be prevented from extending mortgages if the one dominant entity that provides the credit scores (which through historical practice and/or policy are required by underwriting guidelines to be provided by such entity) ceased to offer those credit scores. Perhaps more subtly, though no less of a concern, an operational risk would exist if a credit score model itself were flawed or otherwise could be improved to more accurately quantify the risk posed by prospective or current borrowers.

This Paper addresses operational risks posed by the overdependence on a singular legacy third-party credit scoring provider as well as steps we can take as we move forward out of the Financial Crisis to put this country on stronger financial footing, including by opening the consumer credit markets to non-legacy entities for the provision of third-party credit scores designed to offer more nuanced and increased credit risk predictability. Credit scores remain vital for consumers in the United States to achieve the American Dream, whether that dream is owning their own home, attending college, starting their own business, or having access to a car of their own to get to and from work.

This country has always welcomed competition in the marketplace, and diversity in the third-party credit score industry where credit score models must pass a rigorous validation process should be no exception. Acceptance of such diversity can help reduce operational risks presented by an entrenched system dominated by a single provider, encourage innovation and technological leaps and incentivize providers of credit scores to improve their statistically-derived models (including by competing to have their models score more of the population and thereby allowing for greater predictability in consumers' credit riskiness) to cover all eligible consumers who wish to partake in the U.S. consumer financial markets and help bring our nation back to a state of economic prosperity.

The Issue: Operational Risks Posed by Reliance on a Single Third-Party Credit Scoring Provider

The U.S. consumer credit market heavily relies on one entity that has historically provided the third-party credit scores that are integral to consumer credit extension decisions. We owe it to ourselves to look beneath the surface to examine whether a de facto single-provider legacy system set in place in the previous century best serves the consumer financial market needs of the twenty-first century. If we do so, it does not take much digging to realize that over-reliance on any single legacy third-party credit score system presents significant operational risks to financial regulators, the consumer lending industry, consumers, and the U.S. economy as a whole.

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