Five federal agencies including the Federal Reserve, Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and National Credit Union Administration (NCUA) have essentially green-lighted the mortgage industry’s use of alternative credit data in underwriting – however, the agencies indicate that more work needs to be done to create standards related to how the data is used, so as to protect consumers.
In a joint statement released Tuesday, the agencies say the use of alternative credit data may provide benefits to consumers, including expanded access to credit and more favorable pricing and terms for loan products.
Alternative credit data includes information not typically found in consumers’ credit reports. Essentially, it is cash-flow data derived from consumers’ bank statements. By accessing and analyzing a mortgage applicant’s bank statements, a lender can more easily determine their creditworthiness, particularly when the consumer is self-employed (i.e., not a W-2 wage earner) or has little to no credit history. The analysis might take into account such factors as whether the consumer pays their utilities or rent on time.
As per the statement: “The agencies are aware that the use of certain alternative data may present no greater risks than data traditionally used in the credit evaluation process. For example, the agencies are aware that some firms are automating the use of cash flow data to better evaluate borrowers’ ability to repay loans. While this is a rapidly developing area of innovation, analysis of cash flow data generally focuses on assessing whether a borrower is able to meet new or existing recurring obligations by evaluating income and expense activity over time.”
Importantly, however, lenders must use this data responsibly. That includes getting express permission from the consumer to access to their cash flow data, as well as explaining clearly how that cash flow data was used in underwriting.
The agencies also acknowledge that there could be benefits to using alternative credit data in conjunction with traditional credit data.
“For example, some firms may choose to use alternative data only for those applicants who would otherwise be denied credit, often called a ‘Second Look’ program,” the agencies write in the joint statement. “Used in this fashion, Second Look programs may improve credit opportunities. Second Look approaches must also comply with applicable consumer protection laws.”
Importantly, the use of such data must be part of a well-thought-out compliance management program.
“A well-designed compliance management program provides for a thorough analysis of relevant consumer protection laws and regulations to ensure firms understand the opportunities, risks and compliance requirements before using alternative data,” the agencies write. “Based on that analysis, data that present greater consumer protection risks warrant more robust compliance management. Robust compliance management includes appropriate testing, monitoring and controls to ensure consumer protection risks are understood and addressed.”
The statement does not outline or propose any specific regulations with regard to how alternative credit data is used – but it is likely that present regulations will need to be modified accordingly.
“As with prior developments in the evolution of credit underwriting, including the advent of credit scoring, the use of alternative data and analytical methods also raises questions regarding how to effectively leverage new technological developments that are consistent with applicable consumer protection laws,” the agencies write. “Applicable consumer protection laws, include, as appropriate, fair lending laws, prohibitions against unfair, deceptive, or abusive acts or practices, and the Fair Credit Reporting Act.”
It should be noted that the statement only addresses the use of alternative credit data from a consumer protection perspective.
Also, it should be noted that the agencies are not advocating for a particular credit scoring model that uses alternative credit data.
Government-sponsored enterprises Fannie Mae and Freddie Mac have been exploring the use of alternative credit data in underwriting for years now and have mostly built-out the necessary infrastructure to support its use. In addition, numerous fintech firms are exploring the use of alternative data in underwriting.