Prof. Michael Staten Take Charge America Endowed Chair and Director Take Charge America Institute

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2 Prof. Michael Staten Take Charge America Endowed Chair and Director Take Charge America Institute Center for Capital Markets Competitiveness U.S. Chamber of Commerce, Washington, DC October 28, 2014

3 Risk-Based Pricing What is It? Tailor the price of a loan to the borrower s estimated likelihood of repayment Why did it change the industry pricing structure? Borrowers differ greatly with respect to how much it costs to provide them a loan product Advances in technology and data processing improved lenders ability to measure risk, and do it with sufficient precision to be able to adjust the loan price to match a borrower s risk. => Tailored pricing gave lenders the economic incentive to say yes to both low risk and high risk borrowers

4 Lenders View Loan Applicants Through a Fog of Uncertainty Without specific information on individuals, all borrowers look the same, and receive the same interest rate

5 Credit report data (and credit scoring) refocus attention on the individuals in the pool And, risk-based pricing gives lenders an incentive to say yes to riskier applicants Prob of Default Index of Characteristics

6 Benefits from Lifting the Fog of Uncertainty Around Borrowers and Tailoring Pricing Financial Inclusion: wider participation in consumer loan markets Less qualified (higher risk) borrowers can still get loans Lower-risk borrowers don t pay as much, and remain willing to borrow. Lenders aggressively compete on price for their business Credit more readily flows to those willing and able to take on debt at the quoted price

7 Remarkable Increase in Bank Credit Card Ownership for Lower Income Households (% of HHs with at least one general purpose card) Lowest 2nd Lowest Middle Income Quintile 2nd Highest Highest

8 : Low-Income Households Enjoyed the Largest Gains in Access to Credit (% change in proportion of HHs Using Non-mortgage credit) Percent Change Lowest 2nd Lowest Middle Second Highest Income Quintile Highest

9 Accountability: a special function served by credit reporting and risk-based pricing The credit bureau is the most standardized and most extensive reputational system humankind has every known. Daniel B. Klein, 1997 To the extent that preserving reputations encourages consumers to alter their behavior, then through the market s evolution of the credit bureau, commerce promotes morality as though it were guided by an invisible hand. Klein, 1997

10 Benefits from Lifting the Fog of Uncertainty Around Borrowers and Tailoring Pricing Financial Inclusion: wider participation in consumer loan markets Less qualified (higher risk) borrowers can still get loans Lower-risk borrowers don t pay as much, and remain willing to borrow Credit more readily flows to those willing and able to take on debt at the quoted price Fairness: objectivity empowers consumers With risk-based pricing, consumers earn their opportunities based on their own past credit performance RBP encourages responsible credit use by rewarding good payers and penalizing bad payers

11 Risk-Based Pricing Operationalized: Only as good as the underlying assessment of risk Any discussion of the impact of RBP is intertwined with an assessment of credit scoring and supporting decisionassistance tools (e.g., credit reporting system) RBP encourages innovation in risk-assessment tools because it rewards lenders who find a way to say yes to underserved consumers As of 2006, million Americans had limited or non-existent credit files But, since then the industry has made substantial progress in collecting and utilizing alternative payment data to evaluate (score) consumers with thin or non-existent files.

12 What Underpins the Remarkable Availability of Consumer Loans in the U.S?

13 No-Hit Population Becomes Scoreable After Inclusion of Rental Payment Data (Breakdown for 11% of subsidized housing sample with no credit report) Risk Segment After Rental Data Included Percentage of No-Hit Population Avg. VantageScore 3.0 After Inclusion Prime 59% 688 Nonprime 38% 649 Subprime 3% 586 Total 100% 670 Source: Experian, 2014

14 The Bottom Line on Credit Scoring and Risk-based Pricing Because of dramatic improvements in scoring and pricing for risk, tens of millions of U.S. households have gained access to credit that : Allows them to make capital investments in durable goods (cars, homes, appliances, education) that provide a stream of benefits over the years and improve quality of life Provides a bridge to meet unexpected expenses or sustain them through temporary disruptions in income