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There is more to credit scoring than just blacklisting defaulters

CRBs get data on when you pay and when you don’t pay. [Istockphoto]

Credit information sharing is coming of age. Recent interest in credit information sharing has been sparked by credit scoring in particular because many believe the scores are used to blacklist, denying millions of Kenyans access to credit.

A similarly large number of commentators and observers believe credit scoring is a great step forward in enabling micro and small loans both for individuals and businesses, and they point to Fuliza as an example.

Fuliza, we are told, lends over Sh1.57 billion a day, to millions of Kenyans. Let us shed light on the truth.

Economists and management experts talk about information asymmetry to refer to the circumstances where one party in a transaction has more information than the other. This causes inefficient transactions and market failure. One of the most prevalent in lending is adverse selection.

To appreciate the information asymmetry problem, consider when you are buying a second-hand car along Ngong Road or any of the thousands of car yards. The sellers are more likely than you to know the actual mechanical condition of the car you are trying to buy.

For you to have similar knowledge, and therefore better estimate the value of the car, you would have to spend time and money, for example by coming with your own mechanic to test the car (which some do!).

But consider when you are buying health insurance. The balance of information is in the opposite direction. You have a better appreciation of your state of health than the insurance company. This is generally the case in lending transactions.

The lender will have less information than the borrower about the latter’s exact financial health. Since it is costly to obtain information, lenders will tend to gravitate towards market segments such as large corporates where information might be more readily available.

Various innovations have been tried to overcome the information asymmetry problem in lending. Credit scoring is one. As our luck would have it, it turns out that by examining your history we can make useful predictions about the future. To return to the second-hand car example, if a particular yard has a history of disclosing the true state of their cars, they will probably do so today.

That leaves us then trying to quickly and cost-effectively find your credit history. You might have borrowed from a bank before. Or a sacco. Or even your neighbourhood greengrocer. You probably pay rent, water, or electricity at the end of the month.

All this is credit information. Markets have responded by creating credit information sharing. And to undertake these tasks – credit reference bureaus.

Kenya has three credit reference bureaus (CRBs), licensed by the Central Bank of Kenya. The current debate is how well this market mechanism, which is expected to improve the credit market, is working.

As is often the case in human endeavour, there is a fair amount of finger-pointing. For lenders, it is a convenient scapegoat to give negative listing at the CRB as the reason they did not give you credit. However, nobody is listed only negatively.

The law requires full file information sharing. CRBs get data on when you pay and when you don’t pay. To guard against misuse, lenders can only access if they are contributing data!

The CRBs then use the full file data to generate your credit score.  Generally, you are doing poorly when your score is low and better when your score is high. And it brings us back to the information asymmetry problem.

If I only know of the one time you delayed payment, and not the thousands of times when you have paid on time, then my information is bure kabisa. That is why the industry has been urging the Central Bank of Kenya to allow more data such as from utilities. This is advantageous to customers because it will improve our scores.

But what should a customer do if they listed erroneously? Credit Information Sharing Association of Kenya (CIS Kenya) runs a dispute resolution mechanism - Tatua Centre - to deal with exactly that question.

In existence for six years, the centre has been resolving an average 200 disputes annually. 

Housed at the Kenya School of Monetary Studies, CIS Kenya is a membership organisation, comprising institutions participating in credit information sharing.

How are credit scores to be used? First, scores are not an either-or proposition. You cannot and should not attempt to use them for a binary yes or no decision. Rather they are a measure of risk. They allow you to estimate the probability of default. 

Secondly, they are the first step in risk-based pricing. To price the risk, one must calculate loss given the default. This latter step involves collections. What happens when default occurs?

Does the entire outstanding amount get lost or is some or all of it recovered in the collections process? Fortunately, there is sufficient industry-level data. Combining the two enables the lender to determine the expected loss of any given loan. That expected loss is what is worked into the cost of the loan.