Reputation vital for your credit profile
The tools are now available to make the whole lending process less hit-and-miss
redit is a hugely important part of the global economy and also has a major effect on the quality of individual’s personal and professional lives, from making everyday purchases with credit cards to borrowing larger sums for investing in vehicles, homes or businesses. The world is governed by budgets and paycheques, and people frequently require credit to meet their obligations.
Dramatically limiting access to credit would therefore have a significantly negative impact, doing harm to businesses and the economy as a whole. In fact, a rise in credit level is a sign of a healthy economy; according to the Journal of Economic Literature, a 33 per cent increase in private sector lending results in a 1 per cent growth in GDP.
Today, it is common practice to extend credit simply based on current salary. This is far from the best, or most accurate, way to gauge creditworthiness. This is where credit reporting and credit scoring can come into play, as they empower public and private sector institutions to determine — with a certain degree of accuracy — the future financial behaviour of customers based on vital information about past performance.
This strengthens companies’ overall financial decision-making processes, and makes having a bad credit history an undesirable trait for customers. Credit reporting and credit scoring help not only lenders, but also benefit borrowers and the wider economy. They provide information that depicts a borrower’s credit history, protects creditors from risk exposure, prevents application fraud, shields consumers from financial mismanagement, and increases profit-making opportunities for lenders as well as borrowers.
Furthermore, they reduce the cost and turnaround time of lending decisions. In a simpler age, word-of-mouth was everything, particularly in small, close-knit communities where just about everyone knew just about everyone else. This familiarity created a special kind of social contract, incentivising people to honour their debts or risk a tarnished personal reputation.
Neighbours spreading the word about outstanding debts could leave an indelible stain and damage social standing. This informal system proved most effective with well-known customers, who lived nearby and demonstrated an unblemished past of repaying debts and in a timely manner.
Informal communities of businesses shared information about those who repaid their debts and those who didn’t. But, for obvious reasons, few businesses would extend credit to customers they didn’t know.
Today, in our globalised world, credit reporting and lending continue to rely on this age-old premise. Individuals and businesses still care deeply about their image and, as borrowers, seek to protect their reputation by meeting their obligations on schedule.
Beyond earning a good reputation, borrowers who show a strong payment history are also likely to profit from more favourable interest rates and credit terms. This is because individuals who have a good track record are considered less likely to default, making them less of a credit risk and a greater priority for banks. This has all made living with a bad credit history a difficult and often costly feat.
Without a decent credit rating, individuals may suffer from less favourable interest and credit rates, rejected credit requests and loan approvals, and higher insurance premiums.
Coupled with this is the fact that the financial crisis made banks more prudent in their credit assessment, driving them to rely less on name lending and more on factual information.
Individuals with good repayment histories use their “reputation collateral” to access further credit. This enables them to secure better credit terms and speedier access to credit and credit decisions.
By giving lenders tools that allow them to better classify risk, they can price products not only by type but also according to a borrower’s risk classification. Theoretically, if a prospective borrower comes through the door and has a fantastic repayment record, the lender can charge a lower risk premium or offer them more credit. However, the decision of what and how much to lend remains at the sole discretion of the lender, and depends on a number of factors that contribute to any given lender’s risk appetite.
Successful integration of such tools results in the creation of a self-discipline mechanism that has proven to be effective in preventing default. For individuals who seek to realise their dreams — whether entrepreneurs hoping to launch a new company or established business leaders targeting future growth — the ability to build reputation collateral has dramatically increased their options and eased access to much-needed sources of funding.
Credit scoring and credit reporting have also come on in leaps, giving banks the vital information they need to make informed decisions about lending. The credit environment has matured significantly. By expanding on the work that is currently underway in this area, we will soon be able to provide appropriate and data-driven credit to everyone, contributing to the long-term growth and diversification of the UAE.
The writer is CEO of Decision Analytics company Qarar.