Why Australia needs a better system for credit scores

Australia’s credit rating system is failing both borrowers and lenders. Many borrowers are unaware of their own credit scores and our research shows^[1] they have trouble applying for suitable loans. Lenders are also struggling with too little information, causing them to extend loans to those they shouldn’t and restrict loans to worthy borrowers.

Upcoming changes^[2] to Australia’s credit reporting system could remedy these issues.

Under the new credit reporting regime^[3], both lenders and borrowers will have access to more data, such as monthly payment histories on loans and credit cards. This will help consumers understand their own creditworthiness, improve their credit scores and shop around for lower interest rates.

The new data will arm banks and other lenders to make better lending decisions. But it should also level the playing field by giving new entrants more information, helping them to compete with the established lenders.

Read more: Forcing the banks to hand over our credit history might help with a home loan but it has risks^[4]

My research^[5] with Luke Deer examined loan applications to SocietyOne. This is a peer-to-peer lending marketplace that specialises in unsecured personal loans.

Borrowers are only accepted onto the SocietyOne platform if their credit scores can be verified. Substantial “underwriting^[6]” is required to ensure borrowers are of sufficient credit quality.

Underwriting involves evaluating a borrower’s income and cash flow, based on bank statements and other public information.

Despite this labour-intensive and time-consuming process, which requires individuals to submit copies of their documents to third-party lenders, lenders do not receive a complete picture of the potential borrower’s financial situation.

A borrower may report only part of their true financial situation – for example, by sharing information from only one of multiple accounts. Without an accurate picture of creditworthiness, lenders could be extending loans to borrowers that should be rejected, and others might not receive loans they should qualify for.

Read more: Business Briefing: what happens to your credit history^[7]

This is where the new credit reporting regime^[8] comes in – there will be much more data. In addition to monthly payment histories, there will be red flags on any missed payments of more than 14 days. The current system only flags missed payments of more than 60 days or bankruptcies only.

Credit reports will include information about current accounts you hold, what accounts have been opened and closed, the date that you paid any default notices, and how well you meet your repayments.

The shift towards comprehensive credit reporting should reduce the time required to underwrite loans and allow loans to be priced more efficiently. This is in part because it will reduce the risk of lending to people who are risky borrowers, and so will lower costs^[9].

While this means that borrowers with good credit history will benefit from good behaviour, lower credit quality customers may face higher borrowing costs, or be left searching for alternatives.

But it also opens up more opportunity for borrowers to improve their credit rating by acting on any red flags.

Australia has lagged other developed countries in adopting positive credit reporting. Up to this point, the large banks have had a significant informational advantage over new entrants. Because many of us have accounts with the larger banks, they simply had access to information that other lenders don’t.

As well as opening up the market to new borrowers and lenders, the new comprehensive credit reporting regime will also likely lead to the automation of more financial services and the inclusion of more data sources.

For higher-risk borrowers, novel techniques to assess credit risk (such as analysis of social media^[10] accounts) may be the answer to distinguish good borrowers from bad.

This will partially eliminate the need for costly processes in loan underwriting. But prior experience from an over-reliance on credit scores^[11] in the United States shows that careful assessment of borrowers remains vital.

It could also have the side effect of reducing the prospects of misconduct by either borrower or lender at this stage.

Comprehensive credit reporting should lead to, in aggregate, lower borrowing rates for lower-risk individuals and incentives for higher-risk individuals to improve their position. However, it remains to be seen whether this will lead to a greater degree of exclusion or predatory loans for riskier borrowers.

References

1. ^{^} our research shows (sydney.edu.au)
2. ^{^} Upcoming changes (treasury.gov.au)
3. ^{^} new credit reporting regime (treasury.gov.au)
4. ^{^} Forcing the banks to hand over our credit history might help with a home loan but it has risks (theconversation.com)
5. ^{^} research (sydney.edu.au)
6. ^{^} underwriting (www.investopedia.com)
7. ^{^} Business Briefing: what happens to your credit history (theconversation.com)
8. ^{^} new credit reporting regime (treasury.gov.au)
9. ^{^} lower costs (www.investopedia.com)
10. ^{^} of social media (knowledge.wharton.upenn.edu)
11. ^{^} over-reliance on credit scores (academic.oup.com)