Public discharge, but private gate-keeping: do we need to examine the role of credit scoring?

Damon Gibbons

The issue

The number of personal insolvencies has risen dramatically in recent years. In England and Wales the number of annual insolvencies has increased nearly four-fold from 35,600 in 2004 to 134,142 in 2009.

Whilst changes to insolvency rules introduced by the Enterprise Act 2002 reduced the length of time required for debtors to be discharged from insolvency from a typical period of between two and three years to just twelve months, and whilst one of the policy objectives of insolvency systems is to provide debtors with a ‘fresh start’, insolvency is likely to have a long term negative impact on the ability of individuals to access to financial services, particularly credit, which makes it harder for them to participate in society and has wider socio-economic implications.

The decision to lend, or not, remains with financial services providers who make decisions primarily by using automated credit scoring systems, and which involve the use of insolvency flags.

However, there is a lack of transparency concerning the use of credit scorecards and the way in which insolvency flags affect access to credit and/or the cost of credit offered as a result of risk based pricing.

Lack of transparency in credit scoring practice

Credit scoring systems are not subject to formal rules other than in respect of general anti-discrimination law. Although a set of guidelines for the development of credit scoring systems was drawn up by the industry, with the support of the OFT, in 1993(updated in 2000), these contain only general principles of scorecard design and commitments to communicate decisions effectively to rejected applicants.

We consider that credit scoring systems used by lenders may be a barrier to rehabilitation to credit markets because they could:

(i)Exclude former insolvents completely through the use of insolvency flags as ‘super-fails’ in credit scorecards

(ii)Result in former insolvents failing to meet cut-off scores where their other characteristics would have justified a decision to lend

(iii)Result in higher costs of credit for this group due to the application of risk based pricing

Existing evidence on the impact of insolvency flags on access to credit

There has, to our knowledge, been no investigation of the impact of insolvency on levels and terms of access to credit markets in the UK, and international evidence is also thin on the ground.

Musto (1999) – looked at the impact of insolvency flags on access to credit for former Chapter 7 bankrupts in the US.

Credit reference agencies are allowed to report that the consumer has been through Chapter 7 bankruptcy filings for ten years in the US. However, the detailed information of credit defaults and other derogatory items incurred prior to the petition for bankruptcy are are only kept on file for seven years.

The study examined the impacts on access to credit following changes on the credit file at both the year 7 and year 10 points using an Experian database with over 44,000 records.

Findings

Musto finds that once the bulk of derogatory items are removed at year 7 those with the worst records improve their scores significantly as lenders are no longer able to segment the group.

However, those who had relatively good credit records can no longer be distinguished so ‘this is good news for those with the worst records but bad news for those bankrupts that had relatively good records.’

At year 10, once the insolvency flag is removed from credit records there is a significant increase in the ability of prior bankrupts to obtain credit.

Importantly, the research notes that “A past bankruptcy makes a good file much worse, but has little effect on one that’s already bad”

The study also indicates that some prior bankrupts may be ‘creditworthy’ before the ten years have elapsed but are prevented from obtaining credit by the presence of the insolvency flag, whilst those who remain poor credit risks can be identified through other risk predictors.

Insolvency as an issue of character or driven by external shock?

The question arises as to whether or not the decision to enter insolvency is a matter of character (why some debtors may be more or less willing to enter insolvency) or is primarily driven by exogenous shocks, notably unemployment and consequent house repossession and mortgage shortfall debt (see for example, CLG, 2010, on the role of mortgage shortfall debt in triggering insolvency).

Further research is needed but could be complex, requiring access both to historical data concerning the reasons for prior insolvency, and more recent information concerning credit use and default rates following the removal of insolvency flags. A possible group worthy of study would be those using insolvency to achieve the discharge of mortgage shortfall debt.

Alternatively, a qualitative study of the experience of prior insolvents in gaining access to credit markets, and their attitudes towards the use of insolvency procedures and credit default, may be useful.

Do general economic conditions frame consumer decisions?

Drawing on behavioural economics, it is possible that debtor decisions to use insolvency procedures are ‘framed’ by the wider economic conditions. For example, periods in which there are high numbers of insolvencies may reduce stigma, and vice versa.

This implies that the ‘character’ of debtors may not be constant and that the economic conditions pertaining at the time of the insolvency are potentially important and should be reflected in credit scores. We do not know whether or not this is currently the case.

There are also likely to be differences in the appetite for insolvency between debtors (including differences between those debtors that have entered insolvency). For example, the level of debts required for some to consider insolvency as a solution may need to be significantly higher than for others. Reporting the causes of the insolvency in the period during which insolvency flags remain in place may therefore speed the rehabilitation of some insolvents.

However, this may also segment the group causing some insolvents to find it more difficult to access credit during this period.

Some questions

Given the reduction in the period required for discharge brought about by the Enterprise Act 2002, should there also be a reduction in the period during which insolvency flags remain on file? What were the reasons for not doing so in 2002?

Should we be considering the reporting of the causes of insolvency and ensure the general economic conditions pertaining at the time are taken into account by lenders in their credit scoring systems?

Is there an appetite to commission research in this area in order to inform this, and would a consultation with the industry on this specific point be helpful?

Is there, in any event, a more general case for a review of the credit scoring guidelines, which are now some 10 years old?