What's The Score On Credit Scoring

Credit scoring systems are becoming increasingly popular among lenders, particularly as lenders are pressured to make fair and consistent decisions. How better to be consistent than with a machine based decision system?

Consumer and fair lending advocates have recently raised some concerns about credit scoring. They raise allegations that credit scoring may perpetuate previous discrimination, and systems may be too rigid to enable low income applicants to qualify. These advocacy groups are watching current developments in credit scoring and considering whether to take action.

So what are the real advantages and risks of using credit scoring?

Under ECOA, creditors only need to be concerned about meeting Regulation B's definition of a credit scoring system if the system considers age. A system that does not consider age can be treated as a judgmental system and would therefore not need to be statistically sound, based on empirical data, or "validated".

A system that does consider age must meet the regulations requirements for an empirically derived, demonstrably and statistically sound system. That means the system must be developed using real data drawn from your files or validated using your credit experience. It also means that the system must be developed using recognized statistical principles.

In making your decision about whether to use scoring, you should consider a number of factors. First, what is the bank's current lending volume for each product that could be credit scored. Credit scoring makes decisions fast, efficiently, and consistently. For high volume loan products, credit scoring can significantly increase the bank's efficiency. High volume products also probably have enough loan applications to provide the data base needed to develop or validate the system.

Second, consider your market and what your competition is doing. As use of credit scoring increases, customers should become more familiar with - and used to - being scored. In fact, innovative uses of credit scoring, such as self-operated in-store systems may increase customer receptivity by enabling them to apply and get an immediate decision simply by playing with the computer. On the cautious side, remember that it was such an in-store system that denied the application from FRB Governor Lindsey! Third, and perhaps most important in today's business environment, you need to consider the impact of fair lending considerations. Credit scoring will treat each customer consistently. There will be no differences in judgment between loan officers. The process of developing the system tests the importance and predictiveness of each factor. This means that, at least to some extent, you have already prepared your defense if any criteria are challenged. You already know how predictive and therefore how important a specific factor is.

However, you should also consider another aspect of credit scoring. Because it is based on empirical data and developed using statistical principles, credit scoring strictly limits your ability to be a flexible lender. Special exceptions for customers are actually over-rides to the credit scoring system. Not only will this practice open the door to charges of inconsistent treatment of customers, the practice can even raise serious questions about the validity of the system.

It is this rigidity that fair lending advocates may challenge. They have already raised concerns that credit scoring systems are built on old underwriting criteria. Systems are developed using approvals and denials. The denials reflect the assumption that the applicant would not have been a satisfactory customer. Although there are statistical techniques for handling assumptions about denied applicants, the systems are generally developed based on assumptions about the denials and these assumptions may be the subject of a challenge. Thus, the fairness of your resulting system may depend on the fairness of your existing borrower database.

Finally, consider credit scoring in the context of your CRA program and goals. Credit scoring can provide consistency that can be demonstrated and defended. It may not accommodate your need to be flexible for special lending programs in your community.

ACTION STEPS

Review your existing borrower pool to determine whether it results from open and fair lending. If you have any concerns or questions - and you should - these should be fully discussed with your system developer.
When considering credit scoring, make sure the vendors you talk with are familiar with Regulation B and design systems that comply with the regulation.
Test your system periodically to find out who passes and who fails the system. Consider the impact of the system's decisions on your CRA program and your fair lending efforts.
Do not ever make a practice of overriding the system to approve loans to target groups. That invalidates the system.
Consider maintaining special lending programs to target groups and for special credit programs for which credit decisions will be made judgmentally. In future years, these special credit programs may provide a data base that can be used to redesign your credit scoring system to take into account any flexible underwriting that you performed judgmentally.