Credit scores and the willingness to repay in the age of Covid-19
The coronavirus continues to spread at an alarmingly exponential rate. In addition to the devastating toll it has taken on those infected, the pandemic has literally upended the lives of nearly everyone on earth.
It is unclear how long this situation will persist, or how much worse the situation will get, but it has certainly left its mark on the economy.
Indeed, in just a few short months, global financial markets have been pummeled with historic volatility, and losses that have wiped out years of growth. Major retailers are shutting down stores everywhere, and small businesses are struggling to keep afloat. In their wake, millions of employees around the world are being laid off indefinitely, and unemployment is already on a sharp rise. Still other employees, who are not let go, may have their hours cut, or be forced into quarantine and unable to work.
In all events, the declines in business revenue and individual income are likely going to drive up the need for short term credit very quickly. This need may be further exacerbated by the fact that many small businesses and families have exceedingly little savings to aid them through these times. For example, according to the Federal Reserve Board’s Economic Well-Being report, 40% of Americans do not have enough cash to cover a $400 emergency expense, and many small businesses have less than one month of cash in their reserves.
While there is no shortage of available credit providers, including credit card companies, retail banks, credit unions, and online lenders, many people may not qualify for loans if they lack employment or collateral, or will otherwise be forced to pay exorbitant interest rates. This has always been the case for traditionally “unbanked” or “thin-file” groups, who have struggled to find affordable credit, but may now be the unfortunate reality for previously creditworthy borrowers as well. It seems the game has changed for everyone.
The game has changed for credit providers as well. In this new “black-swan” reality, traditional credit scores, which are modeled and derived from historical financial data, may be less predictive today of borrowers’ likelihood to repay their loans than in the past. Part of the reason for this may be related to an objectively changed financial “ability” to repay, and lenders will need to assess this very carefully. Yet another reason exists, however, which is more psychological in nature, and that is borrowers’ “willingness” to repay.
We know, for example, from psychology and behavioral economics that people’s behaviors are often guided by their emotions and personal characters. Sometimes, such as in the recent phenomenon of consumers hording toilet paper, emotion-driven behaviors can even be irrational. These aspects of personal character will likely play a significant role in today’s loan performances and should be considered in credit scoring.
Actually, personal character has always been a key element of credit scoring. Trustworthy and responsible borrowers, for example, may be considered more dependable and committed to their financial obligations, and less likely to default. And, in today’s uncertain times, such traits may be all the more relevant. In a situation of sudden and unexpected lost income, for example, some responsible borrowers may decide to curb their expenses and/or liquidate certain assets in order to maintain timely credit payments, whereas others may take on additional debt or allow themselves to go into temporary arrears, perhaps even in anticipation of external assistance from government relief programs. In other cases, some anxious borrowers may take out more credit than they actually need in anticipation of future losses and to help gain a feeling of control over the unknown situation, only to find that they can no longer afford the new payments if their financial situation fails to improve.
In other words, many of today’s financial decisions are actually psychological decisions. Therefore, credit providers who are able to incorporate psychology-based credit solutions to augment their current models will likely be better equipped to evaluate new loan applicants, and ultimately lower their portfolio risks, while extending more credit to responsible borrowers in their times of need.
Character-based credit scoring solutions typically take the form of brief psychometric questionnaires, in some cases requiring no more than three-to-four minutes to complete. There are often no right or wrong answers in these questionnaires, but rather responses are profiled based on applicants’ behavioral preferences and response times. Lenders can then integrate those score profiles into their decisioning processes.
Psychometric solutions such as these are relatively new to the world of consumer credit, but have already shown promise for facilitating financial inclusion in many countries around the world. In our new age of Covid-19, when a borrowers’ personal character may be especially indicative of their financial behaviors, psychometric credit solutions will likely become increasingly valuable for loan decisioning.
By Saul Fine, PhD. Founder and CEO of Innovative Assessments