Two powerful and interacting forces are reshaping U.S. society: the Covid-19 pandemic and the Black Lives Matter movement for racial justice. Both require an urgent reassessment of the status quo, and both have shown how our credit scoring system is failing – not just in terms of accuracy and reliability, but in terms of equity, equity and fundamental fairness.
It is vital that alternatives to this outdated system are supported as leaders and candidates come forward with proposals for economic recovery and the Consumer Financial Protection Bureau begins modernizing the country’s fair lending laws and open funding framework this fall.
It is time to stop using credit scores and use available data for “cash scores” to assess the creditworthiness of millions of consumers who do not have a credit score or who have an inaccurate or out of date score – disproportionate young, black, and Hispanic, first and second generation immigrants, and / or low and middle income consumers.
Rising credit scores are not good news
The Wall Street Journal recently found that banks are “flying blindly into a credit storm” and are sharply pulling back on lending to US consumers. The reason? Banks can no longer tell who is creditworthy.
Creditworthiness has continued to rise on average during the pandemic, despite the real economy suffering the worst quarterly decline in modern history. Due to the rapid outbreak of the crisis and the numerous requests for payment that banks are granting consumers, credit reports do not appear to be in default for months.
Since lenders cannot tell which applicants cannot repay, they have no choice but to tighten their standards and slow down lending. That means fewer new customers for banks and fewer loans for everyone at a time when many need it most.
In a stable economy, credit scores (when available) provide a reasonable measure of a person’s relative likelihood of repaying a loan. But in times of extreme economic volatility, they prove completely unreliable.
Credit scores fail equality, fairness standards
And credit scores are not just lacking in accuracy due to Covid. They do not meet the important standards of equality and justice that have been promoted by the Black Lives Matter movement.
The reality is that our current credit system has long penalized blacks and other colored people. We can trace this back to the practice of redlining in the 1930s – the systematic denial of credit in black neighborhoods and other areas where people of color lived.
Although federal laws were later enacted to combat this type of overt discrimination, the practice has left a lasting legacy and a growing influence over generations. If your parents couldn’t get a loan decades ago, they may not be able to serve as sponsors or co-signers for you now, and the cycle continues.
In fact, the likelihood that People of Color will still have inaccurate creditworthiness or lack thereof decades after the end of redlining is still disproportionately high, effectively excluding them from mainstream lending. More than 27% of black and Hispanic Americans are “credit invisible” or “unevaluable” compared to just 16% of whites.
In a world where you need credit for everything from financing a car to applying for a small business loan to finding a job, the consequences of credit invisibility are enormous. By some estimates, lack of credit could cost you tens or even hundreds of thousands of dollars over the course of your life.
An alternative: cash scoring
We cannot accept this status quo. Our current credit system proves unreliable in times of economic volatility and unfair amid important demands for racial justice. But it doesn’t have to be like this: a just and effective alternative is created.
Credit scoring was developed 50 years ago when very little financial information was available to make quick approval decisions. Since then, access to financial data has increased and powerful new statistical methods developed to analyze it. Regulation is even catching up. Just last month, the CFPB began developing a US “Open Finance” framework that would enable consumers to securely share their electronic financial records and more easily access services that rely on that information.
As an industry, we now have the tools we need to look beyond creditworthiness and holistically assess an applicant’s financial condition, including their income, savings and bill payments. This shift would allow for a more complete and accurate assessment of creditworthiness.
At my company, Petal, we call this analysis cash flow underwriting – or “cash scoring” for short. Cash scoring has the potential to assess the creditworthiness of millions of consumers who have zero credit, inaccurate or out of date – disproportionately young, black and Hispanic, first and second generation immigrants, and / or low – and middle-income consumers .
And we know cash scoring works; a similar approach has been used successfully for years in small business lending to provide capital to wealthy but underserved small businesses.
Not only is using consumer cash scores the right thing to do, it’s also the smart thing to do for financial services companies that want to accurately assess risk. According to a recent study by FinRegLab, cash scores are just as good (if not better) for assessing creditworthiness, they do equally well in all demographic groups, and they can better serve historically underrepresented borrowers.
Unlike traditional credit scores, which take months to reflect changes in financial circumstances, cash scores include real-time changes in income, expenses, and savings – a critical skill amid the economic volatility of Covid-19.
The financial services industry has long been resistant to change, but the events of 2020 require us to discard outdated assumptions and challenge ourselves to do better. Today more than ever, we have a responsibility to ensure that credit is fair and accessible to the millions of people who deserve it.
This column does not necessarily represent the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Jason Gross is CEO and Co-Founder of Petal, a New York-based credit card company with a mission to make credit honest, easy, and accessible. He was a member of the Consumer Advisory Board of the Consumer Financial Protection Bureau and previously served as an attorney at Gunderson Dettmer and Sullivan & Cromwell, where he represented technology and financial services companies.