This piece originally appeared in the April 2023 edition of MortgagePoint magazine, online now.
The current lending landscape has a very mixed outlook—a natural reaction whenever there are periods of economic downturn.
We are all very familiar with the recession of 2008 and the resulting impact it had over the next decade on everything related to our risk strategies and lending practices.
Across the board, CEOs, Chief Risk Officers, and various industry execs have become accustomed to navigating these uncertain economic and social times. Even during the early stages of the pandemic, lenders were tasked with this, and to do so successfully, needed to implement the proper strategies to help them grow without any added risk.
As we prepare for a possible recession this year, many lenders are again adjusting their risk strategies and reevaluating traditional credit models to ensure that they are ready for the months ahead and help manage losses in the case of a potential market downturn.
Understanding the Current Environment
Lenders are already navigating one of the trickiest economies we’ve ever seen. With 2008 in the rearview, it’s important to look back at what we learned from this period, how it can be applied to today’s environment, and examine the underlying economic factors to see where there are fundamental differences.
The driving factors behind today’s market are vastly different from what we saw in 2008. This leaves us with a few positives such as a potentially shallower and shorter recession than what we experienced back then.
On the flip side, new factors such as the unstable job market and the current levels of inflation, have lenders unsure about how to navigate these different levels of uncertainty.
One thing we didn’t have 15 years ago was the level of technology and innovation that we do today. From a data and analytics perspective, the world is much different today.
Naturally, this has triggered discussions in the financial services community around the topic of credit scores and whether they are the strongest barometers for determining a consumer’s ability to pay, when there are now alternative data sources available that have proven to be effective.
Even during the 2008 recession when I was on the VantageScore team, we were starting to pull back the layers and re-examine our risk management practices. We could see even then the fundamental cracks in traditional credit reporting that prevented true financial inclusion and the potential alternative data had for removing those barriers.
While we’ve made significant progress since then, the current market has reinvigorated these conversations as lenders reach a new tipping point.
Embracing New Data Sources in 2023
It's undeniable that credit data-based underwriting practices provide a strong barometer for decision-makers. There’s a reason this has been the dominant practice all this time. However, traditional credit-based underwriting practices sometimes miss key variables when evaluating a consumer’s ability to pay (e.g., job changes, multiple income streams, etc.), and this becomes even more evident during periods of a recession. This is because the system we know has always focused on the lenders and their ability to lend more to consumers versus solving the pain points of the consumer. Thus, the cycle of consumers being locked out of financial services continues.
However, the pandemic sparked an upheaval in consumers making major life decisions, whether that was through professional career changes as part of the last major recession, or factors outside their control that left them laid off. As a result of these shifts and fluctuating income streams, traditional lenders realized that the information they historically had used to assess risk and grant services did not give them the most complete view into consumers’ financial profiles.
For example, with COVID-19 stimulus payments, consumers experienced a fundamental shift in payment practices as they were able to leverage these funds to pay off debts.
As a result, data that went into calibrating traditional credit scores was impacted by an artificially high set of payments being made. With these conditions, more lenders have opened their arms to supplemental data to make it easier to evaluate creditworthy consumers.
Alternative data sources such as cash and bank transaction data present a major opportunity for lenders as they navigate a tumultuous landscape and seek growth opportunities without taking on more risk. In the United States, we’re seeing data that backs up these conversations around alternative data sources.
According to Nova Credit’s “The State of Alternative Data in Lending Report,” 75% of lenders believe that traditional credit data and scores don't deliver a complete picture of a consumer's creditworthiness. As a result, a significant number of lenders (59%) are turning to various forms of alternative data in their underwriting process to fill the gap.
The strength of new data and analytics methods has overwhelmingly proven to be accurate—and now the industry is positioned to effectively embrace and use these new sources and tools to solve the challenges facing credit-excluded consumers.
As I like to remind everyone, this isn’t our first recession, and it definitely won’t be our last. Beyond just improving underwriting, it’s time for lenders to listen to consumers’ needs and really get on the train so they can evolve with where the markets are going this year. If not, they risk getting left behind.
We are definitely in for a wild ride over the next few months, but one that will ultimately result in a much safer and inclusive lending environment for all.