Policy Brief
How Credit Reporting Contributes to Financial Inclusion
Consultative Draft, September 2016
1. Introduction and Background
Financial inclusion has become a public policy priority in many countries. Many policymakers and regulators are introducing measures to advance financial inclusion levels in their jurisdictions and in response private-sector stakeholders are scaling up their efforts to reach unserved or underserved populations.
While in the past definitions of “financial inclusion” varied widely across countries, in recent years there has been a significant convergence. Broadly speaking, financial inclusion can be interpreted as covering three main aspects:
i) Access to the various financial products and services that meet the needs of users (i.e. individuals, firms and government entities). These needs generally include making payments, using credit, savings, investment, and insurance products and services;
ii) Regular usage of those financial products and services, which is strongly related to how valuable they are to the users; and,
iii) The overall quality of those financial products and services, which, in tandem with consumer protection and financial capability, makes it possible for a user to benefit to a greater extent from using those products and services in her or his daily life.
In 2015, the World Bank Group (WBG) and a number of public and private sector partners committed to help promote financial inclusion and achieve “universal financial access” by the year 2020 (UFA2020, http://www.worldbank.org/en/topic/financialinclusion/brief/achieving-universal-financial-access-by-2020 ). UFA2020 envisions that 2 billion currently excluded adults worldwide -- women and men alike -- will be able to have access to a transaction account to store money, send payments and receive deposits as the basic building block to manage their financial lives.
Some specific work has been produced as a follow-up to this initiative, including the joint report of the Committee on Payments and Market Infrastructures (CPMI) and the WBG on the “Payment aspects of financial inclusion” released in April 2016 (http://www.bis.org/cpmi/publ/d144.pdf).
While of utmost importance, access to and usage of a transaction account is just an initial step in becoming fully financially included. Another important objective of public policies in numerous countries is to enable vast sectors of the population, including vulnerable and otherwise disadvantaged individuals as well as micro and small enterprises (MSEs), to access credit[1] on reasonable terms and in a responsible manner.
In the latter context, it is important to introduce the concept of “sustainable” financial inclusion. This refers to the capacity of the individual and M&SE to enter the financial sector and remain within it for a sustained amount of time. With the exception of those voluntarily ending a relationship with regulated financial institutions due to the lack of satisfaction with the products and services, sustainability focuses on the goal of ensuring that the credit capacity of the individual or M&SE is considered via the analysis of credit data and other data which contribute to a fulsome analysis of the individual’s or M&SE’s ability to pay are considered such that the loan offered does not in and of itself lead to over-indebtedness which can result in temporary or permanent exclusion from at least certain financial services (e.g. savings and credit).
For a number of years, the WBG and the International Committee on Credit Reporting (ICCR)[2] have been exploring the role that credit reporting plays, or could further play, in improving access to credit. To this end, in 2014 the ICCR published the report “Facilitating SME access to credit through improved credit reporting” and also has explored how credit reporting contributes to financial institution safety and soundness which is vital to ensuring stable access to credit. These work streams build on the seminal baseline General Principles for Credit Reporting published in 2012.
In this policy brief, the ICCR elaborates on how Credit Reporting can contribute to Financial Inclusion, focusing specifically on access-to-credit issues for both individuals and M&SEs whose credit needs remain unserved or underserved by licensed/regulated financial institutions and/or by other formal lenders that are not financial institutions (e.g. retailers).
2. Credit Reporting, Financial Inclusion and Access to Credit
Credit reporting has traditionally been recognized as an essential tool for sound lending by addressing data asymmetries in the relationship between individual and M&SE applicants and lenders. More recently in many markets credit reporting is also seen as a powerful tool for expanding lenders’ ability to expand access to sustainable credit, while also meeting their need for accurately measuring and pricing risk over time.
It must be noted, however, that credit reporting service providers (CRSPs)[3] do not offer loans or other forms of financing and do not establish the criteria for loan approvals made by financial institutions or other lenders. The role of the credit reporting system (CRS) in this regard is rather to provide useful information to lenders for decision-making purposes.[4] Hence, only lenders can actually tap the potential that a well-functioning credit reporting system can bring to improving responsible access to sustainable credit by making proper use of the information (and often analytical tools) available from CRSPs.
When used by lenders a properly designed credit reporting system (see the General Principles for Credit Reporting to better understand what goes into a well-designed system) can contribute to their ability to expand a consumer’s or ME&S’s access to sustainable credit in several ways. These are discussed in Box 1.
Box 1: How does Credit Reporting support and facilitate access to credit?
1. By helping individuals and M&SEs build their “reputational collateral” via the accumulation of payment history data and other predictive data sets and making these data available to lenders, credit reporting systems may help lenders to expand markets to include unserved individuals and M&SEs. This market expansion, created by the data found in credit reporting systems, means many gain access to their first loan from sources other than informal and/or predatory lenders.
2. Financial inclusion also includes a “quality” component, which can be interpreted as improved terms and conditions, including interest rates, with which individuals and firms access loans and other forms of credit. In this context, by facilitating lenders to price risks more accurately, credit reporting can help lower-risk individuals and MSEs that already have a formal loan in obtaining more affordable and flexible terms (e.g. longer tenors) for subsequent loans.
3. By making access to credit sustainable over time. Usage of credit reporting data can be useful for avoiding over-indebtedness. Over-indebtedness can lead to loan re-payment problems and eventually, depending on the severity of the failure, bar individuals/MSEs from accessing new credit for a period of time, usually four years or more. Where lenders are successful in matching the loan product to the needs and abilities of the applicant the credit offered is sustainable over the term of the loan. New, positive payment history is reported to CRS creating a virtuous cycle of lending, reporting and economic opportunity for consumers and M&SEs.
4. By improving consumer and M&SE financial literacy. Giving individuals and MSEs access to their credit reports and credit scores and providing them with essential information on how lenders commonly evaluate these data they are empowered with new knowledge leading to better credit management skills and understanding of how credit scores work, in particular. Individuals and M&SEs can also contribute to data quality by disputing inaccurate data reported by their lenders or mismatched by the credit bureau which are found in their credit reports.
5. By helping avoid and combat fraud. One of the functions of a CRSP is to properly identify loan applicants identifying information and match applicant identifying data with existing files of data to ensure that an applicant is not trying to obtain credit that would lead to purposeful over-indebtedness where there is no intention to repay. CRSP rules can also help ensure that only those lenders that are members of the CRSP and that have an authorization from an applicant or otherwise have, by law, a permissible use for the data can access the credit report/history of that applicant. Finally, if individuals and MSEs are able to access their credit reports they can identify loans that were not requested by them, important missing data or suspicious activity (e.g. unauthorized queries to their data records by one or more lenders).
6. Credit reporting can also help improve access to credit in an indirect manner, by creating a level playing field for small lenders to compete against larger lenders.
The objective of this Policy Brief is to discuss in a concise manner the key challenges and possible actions in order to leverage credit reporting to its fullest potential as per the above discussion.
3. Access to credit for unserved and underserved individuals
The scenario and key challenges[5]
Unserved and underserved individuals typically include the poor living in urban areas, as well as most migrants, many rural inhabitants and the young adults. These groups often have low and/or irregular incomes, and many of them are also informally employed. They also tend to lack physical collateral to pledge when seeking a loan.
Lenders, on the other hand, are only willing to extend credit if they have a reasonable level of assurance that the applicant will repay the principal, plus interest and any applicable fee(s).
For these disadvantaged individuals, their “reputational collateral” (i.e. which is built on the basis of an individual’s history of fulfilment of his/her financial and other similar obligations) is the only potential source of information that can provide such reasonable assurance to lenders.
A credit reporting system is generally the only efficient and reliable mechanism for collecting and integrating the information that underlies reputational collateral. Developing a credit reporting system that is effective for disadvantaged individuals remains nevertheless a challenge.[6]
First, a reliable mechanism for identifying individuals and for linking them unequivocally with their financial obligations is one of the pillars of effective credit reporting. Establishing reliable identity for disadvantaged individuals is often challenging. Reasons for this range from the exclusion of a large share of the disadvantaged individuals from formal labor markets, to some migrants not wanting to be identified by official sources, to the unreliability and/or limited coverage of the national ID system, or even the total lack of such a system for practical purposes.
Second, much of the economic and financial activity of disadvantaged individuals takes place in the informal sector, where transactions are not recorded. Moreover, in some societies women and/or undocumented migrants, among others, may not be able to have accounts, loans or other credits under their own name, and as a result they cannot build a personal credit history.
Third, in other cases disadvantaged individuals may already be using smaller non-bank financial institutions (NBFIs) such as microfinance institutions (MFIs), but these entities very seldom report credit payment data to credit bureaus, credit registries or other CRSPs. Often, non-reporting is due to regulatory restrictions, lack of incentives for reporting and/or the cost of credit reporting data being high relative to the size of the loan being extended.
Regulatory changes may be needed in some countries to enable CRSPs to include these MFIs if they are not regulated financial entities. On the other hand, in the absence of regulatory incentives for lenders to voluntarily report data to CRSPs, MFIs may see little or no benefit from sharing credit data if their lending methodologies do not use credit data as available from CRSPs,[7] or if they already have information on a significant share of the population who are their clients, which is typically the case for the dominant lenders.
In addition, individuals that already use credit from MFIs in the form of group lending cannot generally build a credit history through this means. Even if credit data and other information at the group level are reported to CRSPs, information on individuals within a group are still needed.[8]
Lastly, in some countries the credit reporting system may use minimum reporting thresholds, and as a result individuals having only small loans or credits would not be reported in the system.
As a result, disadvantaged individuals are typically left with so-called “thin files” - or no credit file at all. It is a well-known fact that individuals without sufficient information in their credit histories/files have little access to credit from banks, other regulated financial institutions or even from real sector formal lenders.
An additional effect of the limited coverage of credit reporting systems in many countries is that credit data and other relevant information that may exist on disadvantaged borrowers will be fragmented. This fragmentation means lenders will not always have a full picture of the creditworthiness of selected applicants and further will be limited in terms of their ability to manage ongoing risks across current portfolios of loans which, in the extreme can give rise to institutional or systemic safety and soundness risks. This hampers one of the key functions of credit reporting which is providing lenders with a full, system-wide picture of an individual’s current indebtedness and historical credit performance so that they can make informed decisions. In some cases, MFI-specific client databases have been created, and some have even evolved into credit bureaus. However, these generally do not solve data fragmentation problems.[9]
Additional legal challenges
Use of certain data by lenders and CRSPs which are not related to specific financial obligations and that might be relevant in assessing the creditworthiness of disadvantaged individuals (and any other individual for that matter) might be prohibited in some countries. Typical data items include an individual’s level of education, marital status and employment record, among others. Actual limitations are determined by local regulations on privacy and on what constitutes a “legitimate purpose” or “legitimate interest” for collecting, distributing and using personal data.[10]
On the other hand, in some countries bank secrecy provisions or other similar laws or regulations may restrict the sharing of data that is specifically related to financial obligations (i.e. credit data) by banks, or even by MFIs and others with CRSPs - and/or the CRSP may be impeded from providing data to lenders that are not regulated by the central bank or the banking regulator.
Moreover, while data and other information collected by certain public records agencies (e.g. national population registers, national ID office, justice administration, etc.) are very often crucial for identifying and assessing all sorts of actual or potential borrowers, a lack of clarity in terms of the way in which CRSPs may access, analyze and distribute such information is likely to make those public agencies reluctant to make their records accessible to them.[11]