The FICO score has long been the most important metric in US consumer and small business lending markets. It is a valuable tool, for sure, but it has had a blind spot for decades. The result has been as many as 70 million Americans being left without access to proper credit. The good news is that private equity markets are finally starting to address this blind spot and the accompanying issues around economic access and inclusion that it has exacerbated.
Elvis and the origin of FICO
FICO’s origins begin in the 1950s, a decade of change and prosperity in the US. It was the start of rock ‘n’ roll – and the beginning of the country’s love affair with credit. The first credit card was issued in 1950 and low-interest home loans from the Federal Housing Administration and the Veterans Administration led to blossoming suburbs, which in turn would lead to an increase in auto and appliance loans.
In 1956, the year Elvis Presley had five number one Billboard hits, an engineer named Bill Fair and a mathematician named Earl Isaac formed Fair Isaac Corp to develop the first credit scoring system. Thirty years later, in 1989, Fair Isaac created the FICO score – a statistical measure of creditworthiness based on credit history reported to the credit bureaus.
Today FICO is everywhere. Ninety percent of the largest US financial institutions are FICO clients, and the company has sold more than 100 billion credit scores. FICO – or its similar competitor, VantageScore – is factored into underwriting for everything from mortgages and credit cards to homeowners and auto insurance.
FICO has proliferated because it is efficient and predictive in most cases. Credit scoring gives underwriters standardised tools to more accurately predict default risk. That’s a great thing. But these tools still have limitations.
The standardisation of ‘bureau-based’ credit scoring has helped spur massive economic growth, but it has also had unintended consequences. As the banking industry has consolidated (from more than 14,000 in 1986, to around 4,500 today) and automated, banks have streamlined and centralised underwriting. That has made them increasingly reliant on FICO and other scores.
The problem is that credit history is not the only information relevant to creditworthiness. Income, savings, cashflows and other important factors that were previously incorporated into traditional underwriting fell by the wayside in favour of a more efficient, standardised score. That narrowed the aperture through which borrowers were analysed, cutting many consumers out of credit entirely.
Today, there are more than 70 million people in the US whose credit history is either ‘thin’ or non-existent. As a result, these consumers have inaccurate FICO scores or no FICO scores at all. This population is heavily skewed towards young, low- and moderate-income, Black, Hispanic and first- and second-generation immigrant populations. As a result, they have to pay more to borrow the same amounts, if they are able to borrow at all.
This lack of access creates extra costs and has additional consequences. A young consumer borrowing at an 8 percent rate because she has a parental co-signer might have a good chance to pay down a well-conceived borrowing balance. One paying 20 percent because he doesn’t have a co-signer has a much steeper hill to climb, even if he borrowed thoughtfully and put the proceeds to good use. The cost of a low credit score has been estimated to be in the hundreds of thousands of dollars over the course of a consumer’s lifetime.
Credit scoring for the 21st century
Fortunately, we believe help – in the form of financial products and services that will better serve this market – is on the way. It starts with the notion that adding sources of data beyond credit history enhances predictability and enables a more inclusive result.
Several forms of data appear to have the potential to meaningfully impact credit pricing for certain demographics. For example, cashflow data that is shared when a customer gives a lender direct access to bank account information can help lenders underwrite thin-file and no-file borrowers more accurately than the primary data points incorporated into FICO scores.
There is already a cohort of young companies that have received private equity funding and that are focused on utilising additional data sources to open up lending markets for thin- or no-file consumers. These include two Volery-backed businesses – Petal in credit cards and Buckle in personal lines insurance – as well as others in the wider market, such as Freedom Financial in debt consolidation, Kabbage in SME finance, Esusu in property rentals and Spring Labs in decentralised data sharing. We anticipate many more innovations in the years ahead that will provide investible opportunities for private equity.
From our vantage point, this is an exciting and important step in the evolution of the US consumer credit market. To reach our full potential as a country, we have to invest in developing all members of our population, not just the ones with good FICO scores.
Emanuel ‘Manny’ Citron is the managing partner of Volery Capital, a private equity firm focused on scaling growth-stage financial services companies addressing climate change and economic inclusion