The road to healthy consumer credit starts before credit is taken out – not in the depth of balance sheets.
Hardly a day passes without British politicians, regulators, watchdogs, and charities raising the alarm that current consumer credit has hit worrying levels – with the expectation being that it will increase even further in the coming years. Last week, the Bank of England (BoE) published its latest Financial Stability Report in which it warns of ‘pockets of risks’ in the UK financial system, pointing at consumer credit as a key area for concern. In the 12 months to April 2017, consumer credit grew by 10.3% – close to the fastest record annual growth rate since 2005. More importantly, consumer credit increased far more than UK household income, which has been slowing down since the start of 2014.
At the same time, many in the UK have had favourable conditions when taking out credit, which has resulted in low loss rates for lenders. The current environment has also meant that interest and risk margins of many lenders have fallen, which has increased the likelihood that the credit scores of borrowers have improved.
With the system giving out more credit while loosening safety nets, the big worry is: Are people actually able to afford what is being granted to them so readily? Who is really checking true affordability across the entire product spectrum of a consumer’s credit exposure?
Clearly, the Bank of England has its doubts, which is why it announced earlier rounds of stress tests and stronger capital buffers. However, such measures can only treat the symptoms of overstretched debt. The measures by the BoE will not be able to change the way in which consumer credit is given out and make sure the system provides the right amount of credit to the right people.
The affordability question is one that needs to be asked at the beginning of the credit cycle – and not retrospectively. Since the 1950s, numerical and automated scoring systems have served as the gateway to our credit system in the UK as well as the US and other economies. These systems stem from a time when it was enough for people to merely tick just a few boxes to demonstrate what they could afford. Since then, we keep applying these credit scoring techniques across all types of new credit products – much beyond the scope of what it was designed for.
With a rapidly changing economy and individual biographies, the criteria for establishing a credit score have diverged from the realities of life for people across the highly-developed markets. Gone is the ‘job for life’ expectancy of previous generations, with the average UK person now likely to have 11 different jobs during their lifetime. Zero hour contracts, multiple part time jobs, freelancers and the ‘gig’ economy highlight the flexibility that many individuals now have. This has been accompanied by a significant increase in the UK’s self-employed: from a recent low of 3.2 million in the fourth quarter of 2000 to just over 4.7 million by early 2016. In fact, self-employment has accounted for 45% of all UK employment growth since early 2008, and if we also count the number of those doing it as a second job, there are now 5m self-employed in the UK, which is equal to 15% of the entire UK workforce.
From the warnings of the likes of the Bank of England, we already know that it is likely that some people might be encouraged to bite off more than they can chew in terms of credit. However, among the many worries in regard to credit, we tend to overlook that there are currently also people who could afford to take out more credit, but are excluded from the system because they are freelancers or gig economy workers – people that can’t be processed by the classic credit scoring system. When I moved from New York to London, I experienced the absurdity of the system myself. Being new in the country and having been mostly a founder (i.e.: self-employed) over the last 10 years I had problems getting access to simple things such as a mobile phone contract, simply because my (logically) ‘thin-file’ credit history meant that ‘the computer said No’.
Hence, conventional credit scoring is leading to a misallocation on two fronts, not just one: credit given at times to those who can’t afford it, and no credit given to those who could afford it but fall through the cracks of data limitations. This is why the answer to consumer debt worries is establishing meaningful credit scoring that takes into account the full picture of applicants. We need to really understand the context of the applicant and get the story behind the data. Technically this is possible today, with AI-driven data platforms able to assess credit applicants individually – just like a human credit officer can by viewing the applicant across a wider set of dimensions and making forward looking assessments. The only difference is that the right technical solution would be less arbitrary and fairer than the decisions taken by thousands of individual officers.
The broken credit cycle needs to be fixed wholesale and there is no better time to do this than now – consumer credit has become a reality of life for many of us and it is much more common than it was just a generation ago. If we want to make sure this credit does what it is supposed to do, i.e. helping spread the purchase of important things across our life, much like a home ownership through a mortgage, then we need to establish a fairer and more accurate gateway.
Written by Aneesh Varma.
Aneesh Varma is founder and CEO of Aire, which provides a new way for lenders to understand and credit score their applicants.