Room for improvement

9 November 2009 | By Natalie Holt

The industry has yet to get its head around the ramifications of the Financial Service Authority’s Mortgage Market Review. The implications for the specialist market alone mean that brokers could end up writing mortgage business differently in the future.

But beyond the headlines of the self-cert ban and individual broker registration the regulator’s proposals for affordability could mean a radical shake-up in the way mortgage applications are processed. The FSA is taking a hard line on the lengths lenders and brokers go to ensure that mortgages are affordable. A big part of this is the role credit scoring plays in assessing affordability.

The FSA has suggested that all credit information should be shared by lenders via credit reference agencies. Lending decisions are generally made up of three parts - a basic credit score provided by a credit reference agency, lenders’ own credit scores and lenders’ individual rules and policies.

“Checking the data that credit ratings agencies hold about consumers will be much more important in future,” says Vera Cottrell, principal policy adviser at Which?. “But the information banks collect from credit rating agencies will also be critical as there is more pressure on lenders to show they have done their homework and checked the affordability of loans.”

Jan Smith, director of industry relations at Callcredit, one of the three big consumer credit reference companies in the UK, agrees.

“Credit scoring will play a much bigger role in lending decisions than it does now,” she says. “If you look at the Consumer Credit Directive or the Mortgage Market Review, the whole focus is on affordability. The only way of assessing that is by having more data available to allow lenders to make sensible decisions.”

But the FSA, while boosting the role of credit searches, appears to be calling them into question at the same time. The proposed clampdown on fast-track would have the perhaps unintended effect of rendering credit scoring obsolete.

Ray Boulger, senior technical manager at John Charcol, has called on the regulator to clarify its position in a recent blog.

“Identity verification can often be done electronically and sufficient information obtained for a lender to safely cut down on the paper proofs required,” says Boulger. “If the credit score is not useful in making this decision why do lenders, the FSA and the ratings agencies all regard it as so important?

“The FSA can’t have it both ways - either the credit score is a valid tool in assessing mortgage applications or it is not. If it is but the same paper proofs are required for an applicant with a high score as one with a low score, what is it achieving?”

But is it right that credit scoring should play such a central role? Recent reports in the consumer press point to widespread inaccuracies on credit profiles such as incorrect addresses and settled debts which appear as still being owed.

All these inaccuracies are time-consuming and frustrating to correct, and if they surface in the course of mortgage applications they could cause sales to fall through. Or so the newspapers would have us believe.

In reality, the Financial Ombudsman Service only recorded 21 complaints about credit reference agencies providing incorrect information in the year to October. In the same period last year just 15 complaints were made.

“We get some enquiries from consumers about credit reference agencies but they are often part of wider complaints,” says an FOS spokesman. “Some borrowers may be unhappy with their credit cards or the way their banks are handling their accounts. An issue with a credit reference agency may crop up as part of that.”

But the FOS statistics alone don’t mean that credit scoring is problem-free - at least, the Treasury Committee doesn’t seem to think so. It recently conducted an inquiry into credit searches, collecting evidence on the effect shopping around for credit may have on consumers’ credit files.

In an oral evidence session held on October 27 the assembled MPs tried in vain to get to the root of the problem. Martin Lewis, founder of Moneysavingexpert.com, told the committee that consumers can decide to go elsewhere after applying for credit with a particular lender. But he argues that any further attempt will be blighted by the fact that they have applied before.

“Consumers may try to go elsewhere but they won’t get a cheaper deal because of the impact of a credit search on their file,” says Lewis. “The system is designed to stop shopping around to the detriment of consumer choice.”

But when pressed at the meeting neither Lewis nor Eric Leenders, executive director of retail at the British Bankers’ Association, could tell MPs the number of consumers who have been disadvantaged by multiple credit scores.

Lenders supposedly take the view that many credit searches in a short period of time indicate that a prospective borrower has been turned down for credit. But written evidence from the Information Commissioner’s Office to the committee seems to suggest that this may not be the case (see box). The ICO says it can’t verify the industry claim that multiple credit searches necessarily mean customers represent a heightened credit risk. It has recommended that the committee should look into this point further.

MPs struggled to establish whether there was a detrimental effect on a consumer’s credit file from shopping around.

“We’re not saying don’t shop around,” Fiona Hoyle, head of consumer finance at the Finance & Leasing Association, told the committee. “What we are saying is that as part of the overall credit scoring and credit rating system, if you are being turned down then there may be some sense in pausing for a while.”
When pressed on the effect of multiple credit searches on consumers’ credit files Hoyle would only concede that “if you are making a large number of applications in a short period of time it will be an element that is taken into account”.

In short, the process of predicting consumer risk accurately based on previous credit history is murky. Cottrell says that what makes the issue so difficult to pin down is that every lender has its own credit scoring criteria.

“We don’t know how credit scores are put together, how fair they are, what kind of behaviour scores take into account or how that behaviour is weighted,” she says.

“These models are not transparent. One of the problems for consumers is understanding what they can do to improve their score. Banks are constantly refining and changing their credit scoring models so it’s impossible for consumers to understand how markets change models - something in your credit file that was once viewed as positive might now be seen as a negative.”

This is true for all parties in the mortgage market, let alone clients. Once upon a time working in the booming financial services industry would be something that would boost a person’s credit score. Two years on and it’s probably something that would count against them.

“There should be more transparency with regard to credit scoring and how borrowers can improve their scores when they try to take out mortgages,” adds Cottrell.

“I’m not talking about manipulating credit scores but there should be more transparency about the things consumers can do to influence and improve their scores, such as tightening up their spending habits.”

But credit reference agencies are not so sure. Smith argues that an overly transparent process could give away complicated lending policies which could be damaging information if it fell into the wrong hands.

“Fraud is so prevalent now that you can’t make credit scoring so transparent that fraudsters think that if they tick all the boxes they could fraudulently obtain mortgages,” she says.

“On one hand there’s an argument for transparency, but that should involve consumers checking their credit files and making sure that their records are up-to-date and relevant to their current circumstances. It’s true that lenders remodel their credit scores regularly but total transparency would just open the gates wide to fraudsters.

“We cannot make the process so transparent that it would open it up to fraud but it should be clear enough for borrowers to understand what their credit file means,” she adds.

The next issue on the agenda for credit reference agencies is that of data sharing. The majority of lenders already pass on most of their data to these agencies, the three biggest ones being Experian, Equifax and Callcredit. But lenders are not obliged to hand over all the information they hold on their files.

“If you only go to one credit reference agency it might not have all the information on you because other lenders haven’t given it their data,” says Cottrell.

But she notes that the credit reference industry has been working hard to refine credit scoring practices so lenders and credit firms are using the best possible information.

“Credit risk tools help lenders differentiate between good and bad risks and given the increase in data sharing in recent years we are continuing to make improvements in their performance,” says Gillian Key-Vice, head of government affairs and regulatory policy at Experian.

“Through our work with the industry and regulators we en-courage the fullest possible sharing of data to enable lenders to make the best decisions. This includes helping them validate affordability in a timely and consumer-friendly manner.”

A valiant standpoint but it doesn’t take into account another limitation of credit reference agencies - lack of access to what is called non-consented data. Granted, the companies probably have to a fairly comprehensive data stack but there is a gap in their know-ledge. This relates to borrowers who have had accounts for around 30 years but who would not have been asked for their consent to their data being shared when they applied for their loan or account. No consent means this information can’t be shared between lenders or credit reference agencies.
A government working party has been set up, which Callcredit sits on, to tackle this problem. Lenders are also involved in the talks but Smith says discussions are at an early stage. She surmises that the cost of implementing wider data sharing would be shared equally between lenders, credit reference agencies and consumers.

The regulator says the importance afforded to credit scoring by lenders is a matter for individual firms, not the FSA.

“Our focus is not on tools but on affordability,” says an FSA spokeswoman. “We are concerned about whether individuals can afford their mortgages. The extent to which credit scores are taken into account is down to each lender. All we want to see is that lenders have properly assessed affordability.”

In answer to Boulger’s argument that credit scoring will be made redundant by the proposed requirement for paper income proofs the spokeswoman says the regulator is not demanding that brokers and lenders should not fast-track deals, simply that they should verify that they have all the information before fast-tracking occurs.

The trouble is that mortgage applications can be notoriously difficult to get through, as most brokers will no doubt testify to. And Smith says credit scoring can provide an easy screen for lenders to hide behind when declining applications.

“Lenders often give the credit score as an excuse to refuse applications when it’s actually another factor,” she says. “It’s easy for them to say they ran a credit check and the individual didn’t pass it when the problem could be something else entirely.”

So although not many borrowers are lodging specific complaints about credit scoring there is clearly work to be done in refining the process. The balance lies in designing a system that is a good indicator of risk while being clear enough to be explained to clients.

More data needs to be shared so credit profiles are more representative of borrowers’ credit histories. But at the same time borrowers need to be assured that their data is being passed to the right firms and that it is adequately protected.

There’s certainly room for improvement and it may be several years yet before lenders, credit reference agencies, the government and the regulator hammer out the ideal arrangement.

Credit scoring is by no means achieving full marks at the moment and it could be some time before it can be classed as a risk-free and flawless affordability-checking tool.