Can alternative data bridge the credit gap?

Whether it’s the rise and fall of payday-loan companies or the exponential growth of the buy-now, pay-later industry – we’re going through a bit of a golden age when it comes to the options for consumers looking for credit.

It could be argued this rise has in part been caused by the substantial increase in demand for credit seen since the UK came out of the Covid-19 pandemic and was thrown headfirst into the cost-of-living crisis.

This, unsurprisingly, has led to fears of a sharp rise in defaults. Indeed, at the start of this year some of the UK’s biggest high street lenders told a Bank of England survey they expected to see the sharpest rise in defaults of unsecured lending since 2009.

And these figures have been borne out in some form of reality, with the average total debt per UK household hitting £65,665 based on the latest figures from The Money Charity.

Based on the state of play as of August this year, average credit card debt per household was at £2,518, while there was a 6.38% change in outstanding credit card balances in the 12 months to August.

Additionally, there was a £27bn jump in the total amount owed at the end of that month when compared to August 2023 – pushing the total to £1.86tn and resulting in a £507.32 jump in the amount owed per UK adult over the year.

With these levels of uncertainty, it’s vital for lenders – now more than ever – to have as clear a picture as possible of who they are lending to.

Traditionally, of course, creditors would judge this on a prospective customer’s credit score – but is the current credit scoring regime fit for the ever-changing market 21st-century lenders find themselves in?

The history of credit scoring

While the history of credit scoring itself only goes back a few decades, credit reporting can date as far back as the 19th century – starting as long ago as 1803 in the UK when a group of London tailors began swapping information on customers who failed to pay their debts.

Reporting began to formalise a couple of decades later, with the Mercantile Agency being the most important of these – founded by merchant Lewis Tappan in 1841.

The organisation set out to systematise rumours regarding debtors’ character and assets, doing so by soliciting information from correspondents across the country – distilling these reports in massive ledgers in New York.

Credit reporting agencies, meanwhile, have their origins as local merchant associations that collected financial and identification information about potential borrowers before selling it to lenders.

Modern-day credit bureaus began to take shape in the early 20th century. These saw retailers begin to offer consumer credit to individuals – all of whom had individual credit managers whose job it was to determine the creditworthiness of an applicant.

As for credit scoring, this started back in the 1950s, although in the beginning these were still unreliable and lenders used different methods to allocate points, changing from one lender to another.

Slowly but surely, these scores began to formalise – evolving into what is widely regarded as the most widely used form of credit scoring, namely the "FICO" score.

Developed in 1989 as a joint project by Equifax and the Fair Isaac Corporation, the scoring system awards points for each factor that can help predict the likelihood of a person repaying debts on time.

Pitfalls

When making lending decisions, lenders have in the past used a variety of data to make a decision, including a prospective customer’s credit history, anything that’s on the public record – including court judgments, bankruptcies and IVAs – account information and even electoral roll information.

However, while it’s widely agreed traditional credit data gives lenders a reliable, foundational understanding of someone’s financial position, the data may lack the depth and currency for the current financial landscape we live in.

This issue was crystallised in the credit information market study published by the FCA last year.

The regulator discovered that CRAs held more credit files than there were people in the UK. As a result, they face a degree of uncertainty as to whether records from different sources refer to the same person, meaning some individuals’ credit files don’t reflect their current financial circumstances.

It also found material differences in data on individuals at the three large CRAs, particularly when it comes to defaults. Under these circumstances, they only held information on defaults for around 30% of matched individuals.

Its findings also suggest that, given the role credit scores can play in getting lending applications approved, data quality is absolutely vital in preventing poor outcomes for consumers.

The pitfalls of traditional data scoring are yet further emphasised by LexisNexis Risk Solutions’ latest Global Consumer Lending Confidence Report, with lenders now 59% less confident in their ability to compete when making consumer lending decisions based on traditional credit data alone.

Meanwhile, when asked what the greatest challenges were facing lenders with traditional credit data, by far and away most said it was the limited visibility they had as to whether a consumer had a negative payment history.

Could alternative data be a solution to this?

One form of "alternative data" highlighted by the report is open banking, with most respondents to its survey suggesting this source provides more accurate assessments of a consumer’s current financial circumstances.

Indeed, the regulator said this form of data gathering has started to offer some alternatives to traditional credit information – with it anticipating that it could be used as an alternative to some types of traditional credit information as adoption becomes more widespread.

And adoption is certainly on the rise, with there – as of July this year – being 10 million consumers and small businesses using it in some form or another.

This is only expected to grow, with Open Banking forming a key part of the Digital Information and Smart Data Bill. First announced by the previous Conservative government before forming part of the King’s Speech, it forms part of what it describes as "smart data".

Described as the "secure sharing of customer data", it explained that Open Banking was the "only active example" of a "smart data scheme". However, it needs a legislative framework to put it on a permanent footing from which it can grow and expand.

It adds: "This empowers customers to make more informed choices and provides businesses with a toolkit to innovate. By empowering consumers to share their data with sectors, we also hope to encourage the economic growth we’ve seen from Open Banking across the economy.

"This is crucial where customer engagement is low, or where businesses hold more information and data than the customer."

Of course, Open Banking is only one source of new and "alternative" data being utilised, and even then, it does have its limitations.

This is particularly true for those who are lacking a traditional credit file, as it only provides lenders with a customer’s transactional history in real time – unquestionably beneficial but only provides part of the story.

Alternative data, meanwhile, can provide lenders with a far more comprehensive understanding of a customer’s current financial situation – including things like income, employment status and payment history. It can also help businesses understand why customers buy things and identify emerging trends.

This tracking is particularly beneficial for the creditworthiness of individuals with limited or sub-prime credit.

And its benefits are already being seen by lenders, with 86% of respondents to LexisNexis’s Global Consumer Lending Confidence Study suggesting that they felt more confident in consumer lending decisions based on alternative credit data.

Increasingly, this is derived from lenders using alternative credit risk scores across the entire customer life cycle – expanding from initial adoption strategies that saw these risk scores used more often at loan origination.

Meanwhile, 64% of respondents are leveraging an alternative credit risk score for portfolio management – showing that lenders are using additional data resources to monitor more closely signs of financial stress.

The journey from informal lists shared between London tailors to today’s sophisticated alternative data sources illustrates how credit assessment continues to evolve with technological advancement. While traditional credit scoring has served as the backbone of lending decisions for decades, the integration of alternative data sources is proving to be a game-changer.

With lenders increasingly using these tools across the entire customer lifecycle, and nearly two-thirds already leveraging alternative credit risk scores for portfolio management, the industry appears to be embracing a more holistic and dynamic approach to understanding consumer creditworthiness.