82031 (Author at Cato Institute) https://www.cato.org/ en To Fix Problems with Credit Reporting, We Need a Better Government Watchdog, Not Biden’s Idea of New Public Credit Bureau https://www.cato.org/publications/commentary/fix-problems-credit-reporting-we-need-better-government-watchdog-not-bidens Dan Quan <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>The Biden‐​Sanders Unity Task Force wants to create a “<a href="https://joebiden.com/wp-content/uploads/2020/08/UNITY-TASK-FORCE-RECOMMENDATIONS.pdf" target="_blank">Public Credit Reporting Agency within the Consumer Financial Protection Bureau</a>” to cure the ailments in the credit reporting industry.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>This poorly thought‐​out proposal, which sounds more Bernie than Joe, amounts to a&nbsp;blunt and uncalled‐​for government takeover of a&nbsp;flawed but largely functioning private industry that supports the most developed and competitive consumer credit market in the world.</p> <p>Let’s face it, the credit reporting industry is not without its own share of problems.</p> <p>Consumers do not trust credit reporting firms with handling their personal data. The epic Equifax&nbsp;<a data-track-hover="QuotePeek" data-charting-symbol="STOCK/US/XNYS/EFX" href="https://www.marketwatch.com/investing/stock/EFX?mod=MW_story_quote" target="_blank">EFX,&nbsp;-0.06%</a>&nbsp;breach in 2017&nbsp;<a href="https://www.ftc.gov/enforcement/cases-proceedings/refunds/equifax-data-breach-settlement" target="_blank">exposed the personal information of 147 million people</a>.</p> </div> , <aside class="aside--right aside--large aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>The credit reporting industry has problems, but a&nbsp;government‐​owned credit agency won’t solve them. </p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>The public is also frustrated with the high incidents of errors in consumer reporting data. According to a&nbsp;<a href="https://www.ftc.gov/sites/default/files/documents/reports/section-319-fair-and-accurate-credit-transactions-act-2003-fifth-interim-federal-trade-commission/130211factareport.pdf" target="_blank">Federal Trade Commission study released in 2012</a>, “<a href="https://www.ftc.gov/news-events/press-releases/2013/02/ftc-study-five-percent-consumers-had-errors-their-credit-reports" target="_blank">one in five consumers had an error&nbsp;</a>on at least one of their three credit reports.”</p> <p>The existing industry practice is perceived to be unfair and discriminatory. A&nbsp;<a href="https://files.consumerfinance.gov/f/201505_cfpb_data-point-credit-invisibles.pdf" target="_blank">2015 CFPB study</a>&nbsp;estimated that 45 million Americans either have no or unscorable credit records. The study further found that “Black consumers, Hispanic consumers, and consumers in low‐​income neighborhoods&nbsp;<a href="https://www.consumerfinance.gov/about-us/blog/who-are-credit-invisible/" target="_blank">are more likely to have no credit history or not enough current credit history</a>&nbsp;to produce a&nbsp;credit score.”</p> <p>However, creating a&nbsp;public credit reporting agency would not solve those issues it purports to address. Instead, enhanced government oversight and private‐​sector innovation are more effective in improving cybersecurity, reducing data errors and bringing about a&nbsp;more inclusive credit system.</p> <p>The public credit reporting agency would not necessarily be more secure and better at guarding consumers’ privacy. The 2015 data breach at the Office of Personnel Management, which exposed sensitive personal information of&nbsp;<a href="https://www.reuters.com/article/us-cybersecurity-usa/millions-more-americans-hit-by-government-personnel-data-hack-idUSKCN0PJ2M420150709" target="_blank">22.1 million people</a>, or 7% of the U.S. population, is a&nbsp;sober reminder that there is no safe haven from massive cyberattacks.</p> <p>A better way to improve cybersecurity would be to subject the credit‐​reporting industry to rigorous supervision by the FTC, which has a&nbsp;wealth of experience and expertise in cybersecurity and privacy. Alternatively, prudential banking agencies such as the Federal Reserve and the Office of the Comptroller of Currency can do an adequate job. In any case, Congress will need to vest this new authority to one of those agencies.</p> <p>The public credit reporting agency would likely continue to be plagued by high incidences of data errors. Since the proposal requires private credit‐​reporting firms to provide data to the public credit reporting agency, we would have the “garbage in, garbage out” problem.</p> <p>A proper solution to improve data accuracy is for the government to diligently exercise its role as the watchdog. Unfortunately, consumers traditionally bear the responsibility of ensuring the data collected on their behalf and without their explicit consent is accurate. It is discouraging to see, for example, that the FTC recommended in the aforementioned 2012 study that consumers “should check their credit reports regularly” as the primary way to make sure their data is accurate.</p> <p>The CFPB has broad supervisory and enforcement authority over the credit reporting industry. It oversees both data providers (also known as furnishers, which are mostly lenders) and credit‐​reporting firms that receive and store credit data. If the CFPB consistently makes improving data accuracy the top priority during its examinations of the industry, the error rate will eventually go down.</p> <p>The public credit reporting agency is also ill‐​equipped to solve the fair‐​credit access problem. The proposal aspires to expand access to credit by ensuring “the algorithms used for credit scoring don’t have discriminatory impacts, including accepting non‐​traditional sources of data like rental history and utility bills to ensure credit.”</p> <p>This well‐​intentioned recommendation has merits, as it calls to attention a&nbsp;big problem and a&nbsp;great innovation to try and solve it, namely, the incorporation into credit files of new data sources to help “credit invisibles” get access to credit.</p> <p>However, the private sector is already innovating. For instance, Experian Boost allows consumers to add on‐​time payments for utility, wireless, and streaming services to their existing credit files. This additional information tends to improve people’s credit scores, especially those “credit invisibles.” The free service has boosted the average FICO score by 13 points per user,&nbsp;<a href="https://www.experian.com/consumer-products/score-boost.html" target="_blank">according to the company</a>.&nbsp;<a href="https://www.marketwatch.com/investing/stock/EXPN?countryCode=UK&amp;mod=MW_story_quote" target="_blank">EXPN,&nbsp;</a>&nbsp;</p> <p>Innovation is proven effective in expanding access to credit, and it is best left in the hands of the private sector. It would be a&nbsp;waste of resources for the government to reinvent the wheel.</p> <p>In addition to failing to address the issues of the credit reporting industry, the proposal raises serious privacy, efficiency, competition and operation concerns.</p> <p>First and foremost, the creation of the public credit reporting agency is a&nbsp;blatant intrusion of consumers’ privacy rights that the government professes to protect. The federal government would potentially score everyone and maintain a&nbsp;huge database that monitors every aspect of our financial lives: how much we owe, who we borrow from, and how much we pay. We would have a&nbsp;de facto social credit system and the country would be one step closer to an Orwellian state.</p> <p>The setup and operation of the public credit reporting agency will be a&nbsp;boondoggle for government contractors at the cost of taxpayers. The federal government has no experience or expertise in establishing or running a&nbsp;credit reporting agency. Many, if not most of the functions, would inevitably be contracted out. And the federal government has a&nbsp;poor track record of supervising its contractors and protecting consumers — just look at&nbsp;<a href="https://www2.ed.gov/about/offices/list/oig/auditreports/fy2019/a05q0008.pdf" target="_blank">how the Department of Education managed its student loan servicing contracts</a>.</p> <p>The requirement to use the public credit reporting agency for all federal lending programs and federal employment would be anti‐​competitive. In a&nbsp;free and functioning market, businesses should compete on quality of services and prices rather than on government mandate. Competition would be especially important if the government score differed from private scores, as this would bring to light and help address the weaknesses of both forms of credit‐​scoring.</p> <p>It is questionable if Congress can force private credit reporting firms to provide data to the public credit reporting agency when they are in fact competing with each other. And will the data be provided free of charge? If not, who decides how much taxpayers should pay for the data? This requirement could also crowd out private‐​sector investment and innovation, leaving both consumers and the public credit reporting agency hanging.</p> <p>The public credit reporting agency will likely be subject to the same regulations that protect consumers. As a&nbsp;result, the CFPB would be tasked with an unworkable position to supervise itself for compliance with the law. Also note any monetary damage the public credit reporting agency has to pay in an enforcement or class action settlement would be ultimately born by taxpayers.</p> <p>The credit reporting industry is an integral part of the most vibrant consumer credit market in the world. The industry clearly has some health issues, but the government option is the wrong medicine. What we need is a&nbsp;real reform that focuses on strong and smart supervision of the industry to protect consumers’ privacy and enhance data accuracy. We also need sound public policies that encourage innovation and competition to achieve fair and equitable access to credit.</p> </div> Fri, 11 Sep 2020 09:49:17 -0400 Dan Quan https://www.cato.org/publications/commentary/fix-problems-credit-reporting-we-need-better-government-watchdog-not-bidens The Evolution of Banking: The 2020 Cato Summit on Financial Regulation — Expert Panel: Increasing Competition in Banking https://www.cato.org/multimedia/events/evolution-banking-2020-cato-summit-financial-regulation-expert-panel-increasing Eric Goldberg, Maria B. Earley, Ron Shevlin, Dan Quan <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Hundreds of innovative firms have now entered into payments, lending, and other consumer financial markets that banks used to dominate. These new entrants have raised the quality, lowered the cost, and expanded the reach of financial products to Americans who were previously excluded. But their growth has also raised questions about the fitness of existing regulation. Does it adequately address consumer protection and prudential concerns about these new entrants? What are the relative roles of state and federal regulators? And how can policy change best encourage entry into banking that will benefit consumers? Join us for an outstanding virtual program, featuring leading policymakers and experts, at Cato’s sixth annual Summit on Financial Regulation.</p> </div> Wed, 09 Sep 2020 15:10:00 -0400 Eric Goldberg, Maria B. Earley, Ron Shevlin, Dan Quan https://www.cato.org/multimedia/events/evolution-banking-2020-cato-summit-financial-regulation-expert-panel-increasing CFPB Can Do Better by Fintechs Than a ‘Policy Tool’ https://www.cato.org/publications/commentary/cfpb-can-do-better-fintechs-policy-tool Dan Quan <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>The CFPB recently finalized three&nbsp;<a href="https://www.consumerfinance.gov/about-us/newsroom/bureau-issues-policies-facilitate-compliance-promote-innovation/" target="_blank">policy tools</a>&nbsp;meant to promote financial innovation by offering some regulatory certainty. But the agency may need to go further to convince fintechs such tools are safe and beneficial.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Two of those tools — the no‐​action letter and the compliance assistance sandbox — equip the CFPB with broad authorities to address various regulatory questions, including fair‐​lending risk associated with the use of machine learning and alternative data in credit underwriting.</p> <p>One example of this is in an August&nbsp;<a href="https://www.consumerfinance.gov/about-us/blog/update-credit-access-and-no-action-letter/" target="_blank">blog post</a>&nbsp;that updated its first issued no‐​action letter to Upstart Network, an online marketplace lender that uses alternative data for underwriting. In the post, the CFPB encouraged fintech lenders to take advantage of&nbsp;<a href="https://www.americanbanker.com/news/mick-mulvaneys-last-move-at-cfpb-aims-to-help-fintechs" target="_blank">such policy tools</a>&nbsp;to reduce their own fair lending compliance risk.</p> <p>More of these no‐​action letters that offer a “safe harbor” from the CFPB might benefit a&nbsp;handful firms, but the market as a&nbsp;whole will not reap the rewards until the agency issues generally applicable guidance.</p> <p>When Upstart applied for the&nbsp;<a href="https://files.consumerfinance.gov/f/documents/201709_cfpb_upstart-no-action-letter-request.pdf" target="_blank">no‐​action letter in 2017</a>, there was a&nbsp;tremendous amount of regulatory uncertainty around disparate impact testing — when disparities are found between groups, though unintentional — as related to the use of machine learning and nontraditional data.</p> <p>Regulatory agencies had little experience with those new and innovative credit models. And there was little regulatory guidance to help new fintech lenders monitor and manage the enhanced fair‐​lending risk inherent in those models.</p> <p>It was against that backdrop that CFPB staff issued a&nbsp;no‐​action letter to Upstart in 2017. In addition to market signaling, one primary goal of the letter was to afford the CFPB a&nbsp;ringside seat to gain experience and expertise that would enable the agency to formulate a&nbsp;sound, general policy in the future.</p> <p>The Upstart letter has a&nbsp;number of novel ideas.</p> <p>For example, a (very welcome) regulatory innovation is the use of a&nbsp;hypothetical model that contains traditional application and credit variables, but does not use machine learning as the baseline for credit‐​access analysis and disparate impact testing.</p> <p>Too often, regulators compare the outcomes of innovation to a&nbsp;distant ideal rather than an imperfect status quo. Regulatory realism that recognizes the value of incremental improvements and gradual harm reduction is a&nbsp;step in the right direction.</p> <p>The Upstart no‐​action letter for the first time&nbsp;<a href="https://www.americanbanker.com/news/good-news-for-fintech-seen-in-cfpbs-no-action-move" target="_blank">provides a&nbsp;detailed roadmap</a>&nbsp;of fair lending compliance. Unfortunately, all of the regulatory and compliance innovation in the letter is confidential and so far, benefits just one company.</p> <p>The regulatory uncertainty that existed in 2017 remains unchanged. What has changed, however, is that the CFPB (through the Upstart collaboration) has now developed a&nbsp;wealth of knowledge about how to manage and mitigate fair lending risk for machine learning models.</p> <p>Now is the time to leverage those insights to develop policies that benefit not just Upstart but the entire industry.</p> </div> , <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>Regulatory agencies should do what they are supposed to do by providing clarity to regulated entities.</p> </div> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>A good start would be for the CFPB to disclose key aspects of model risk management and compliance from its first no‐​action letter.</p> <p>How should a&nbsp;hypothetical model be constructed? How can companies use such a&nbsp;model in access to credit evaluation and disparate impact testing? What are the steps firms may take to monitor and manage disparate impact risk?</p> <p>While there may be many paths to compliance, answers to those questions will provide specificity so firms can learn and develop their own compliance approaches. Sharing the lessons from the Upstart no‐​action letter essentially provides an example of a&nbsp;safe harbor for fair lending compliance that can address much of the existing regulatory uncertainty.</p> <p>It is also important for the CFPB to work with the prudential banking agencies to issue formal fair lending compliance guidance, since bank regulators enforce the Equal Credit Opportunity Act.</p> <p>This would benefit not only fintechs but incumbent banks that also wish to safely use machine learning and alternative data in their credit decisions. Such joint guidance would provide ultimate certainty to the entire marketplace.</p> <p>While the Upstart no‐​action letter was an example of policy innovation, issuing more of such letters on the same ground would be equivalent to innovation‐​by‐​permission. Let the market do what it does best: innovation through competition.</p> <p>Regulatory agencies should do what they are supposed to do by providing clarity to regulated entities. Besides, only firms whose requests are handpicked by the CFPB will benefit from those one‐​off letters, while the rest of the industry continues to be kept in the dark.</p> <p>More importantly, the CFPB cannot sufficiently protect firms that are granted no‐​action letters or approvals outside the agency’s jurisdiction, putting those recipients in great regulatory and legal jeopardy. A&nbsp;significant number of state attorneys general and financial regulators&nbsp;<a href="https://ag.ny.gov/press-release/2019/attorney-general-james-leads-coalition-21-state-attorneys-general-urge-consumer" target="_blank">oppose</a>&nbsp;the CFPB’s innovation policies.</p> <p>This could lead to a&nbsp;scenario that muddies the waters even further. Imagine if the CFPB gives a&nbsp;no‐​action letter or approval to a&nbsp;lender that uses machine learning and nontraditional data. This same lender might subsequently be investigated or sued by one (or more) states for potential state fair lending violations and/​or unfair, deceptive or abusive acts or practices violations about the very conduct “endorsed” by the CFPB.</p> <p>This would create huge confusion and uncertainty in the marketplace.</p> <p>The best way forward is for the CFPB to share lessons with the public; build consensus with prudential regulators; mend fences with states; and put out specific and useful guidance.</p> <p>By doing so, the agency can provide the kind of certainty and clarity firms need to harness the great potential of machine learning and alternative data, while promoting responsible access to affordable credit.</p> </div> Mon, 04 Nov 2019 10:24:12 -0500 Dan Quan https://www.cato.org/publications/commentary/cfpb-can-do-better-fintechs-policy-tool A Few Thoughts on Regulatory Sandboxes https://www.cato.org/publications/outside-articles/few-thoughts-regulatory-sandboxes Wed, 25 Sep 2019 17:22:46 -0400 Dan Quan https://www.cato.org/publications/outside-articles/few-thoughts-regulatory-sandboxes Examining the Use of Alternative Data in Underwriting and Credit Scoring to Expand Access to Credit https://www.cato.org/publications/testimony/examining-use-alternative-data-underwriting-credit-scoring-expand-access Dan Quan <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Dear Chairman Lynch and Ranking Member Hill:</p> <p>I would like to thank the Financial Services Committee for convening its Task Force on Financial Technology and organizing its hearing titled “Examining the Use of Alternative Data in Underwriting and Credit Scoring to Expand Access to Credit” on July 25, 2019. I&nbsp;am writing to express my views regarding the topic of that hearing.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>My name is Dan Quan and I&nbsp;am an adjunct scholar at the Cato Institute’s Center for Monetary and Financial Alternatives. I&nbsp;also advise high‐​growth, disruptive fintech companies. Previously, I&nbsp;led the Consumer Financial Protection Bureau’s (CFPB) fintech office, Project Catalyst.</p> <p>The United States has the most developed and competitive consumer credit market in the world. For example, the credit card industry has seen robust growth since the financial crisis, with $1.07 trillion in outstanding balances as of May 2019.<sup><a href="#_endref1" id="_endn1">1</a></sup> Fintech lending has seen even greater growth, accounting for 38% of the $138 billion unsecured personal loan market in 2018.<sup><a href="#_endref2" id="_endn2">2</a></sup> However, the inconvenient truth buried in those rosy numbers is that we still have a&nbsp;huge financial inclusion challenge. 45 million Americans, or 19.3% of the adult population, don’t have access to credit.<sup><a href="#_endref3" id="_endn3">3</a></sup> These consumers tend to be disproportionately African American, Hispanic, young, and lowincome.<sup><a href="#_endref4" id="_endn4">4</a></sup> Additionally, 53% of small businesses surveyed by the Federal Reserve could not obtain the full financing they sought.<sup><a href="#_endref5" id="_endn5">5</a></sup></p> <p>Now, however, the use of alternative data in credit scoring and underwriting holds great promise for bringing greater access to credit and capital to struggling consumers and small businesses. Underwriting models that include alternative data can increase lending volume, lower interest rates for borrowers, and improve the accuracy of default predictions. In short, alternative data can make lending more plentiful, more affordable, and sounder — with historically underserved borrowers and communities benefitting most.<sup><a href="#_endref6" id="_endn6">6</a></sup></p> <p>Alternative data can include anything that is not currently part of consumers’ traditional credit reports. It can range from account transaction history (known as cash‐​flow underwriting), to educational and occupational information, to social media use and other online or mobile activities. The topic of alternative data sometimes raises concerns about whether it could increase discrimination against protected classes or intrude on borrowers’ privacy. While these are legitimate concerns, it is counterproductive to prevent or tightly constrain the use of alternative data in lending. Restrictions would likely hurt, not help, marginalized borrowers who are overwhelmingly low‐​income and minorities. In fact, a&nbsp;recent study on the racial and ethnic disparities in credit access finds that the lending gap attributed to credit discrimination is much smaller for fintech firms than it is for traditional lenders.<sup><a href="#_endref8" id="_endn8">8</a></sup> Discouraging innovation out of a&nbsp;concern for potential discrimination is therefore likely to undermine financial inclusion.</p> <p>In my experience, not many firms use alternative data in credit scoring and underwriting today. Those that do mostly use cash flow data. For example, fintech lenders such as Oportun use cash flow data to provide credit to “unscorable” or “credit invisible” consumers. Other lenders, like payment processors Square and PayPal, use transaction histories to help them lend to their merchants effectively and efficiently. According to Square, its average loan size is $6,000,8 an amount that most traditional financial institutions find unprofitable to finance. Individual consumers can opt to include data like their on‐​time bill payment history to boost their FICO scores.<sup><a href="#_endref9" id="_endn9">9</a></sup> In my conversations with fintech lenders, none report any convincing evidence that social media data can predict consumers’ repayment behavior. No lender is using it for underwriting purposes in the U.S. A&nbsp;recent paper from the Federal Reserve Bank of Philadelphia agrees that underwriting with alternative data can better predict loan outcomes, resulting in improved terms for borrowers who, under traditional credit criteria, would receive higher‐​priced loans.<sup><a href="#_endref10" id="_endn10">10</a></sup></p> <p>There is no need for new laws or rules just for the use of alternative data. The same laws and rules that ensure fair credit access, privacy protections, and transparency in underwriting decisions equally apply to lenders who use alternative data. On the other hand, regulatory agencies should encourage the responsible use of alternative data by providing greater clarity to lenders in two key areas.</p> <p>First, a&nbsp;transparent, secure, and frictionless data sharing ecosystem is necessary for increasing the use and reliability of alternative data. Regulators should support the Treasury Department’s position that consumers have a&nbsp;right to permission their own financial data for third‐​party use.<sup><a href="#_endref11" id="_endn11">11</a></sup></p> <p>Second, the CFPB needs to issue clear guidance on what responsibilities under the Fair Credit Reporting Act that third‐​party data aggregators and financial institutions have when consumers request to share their financial data through a&nbsp;secure mechanism such as an API. Uncertainty about these responsibilities creates confusion, friction, and can potentially result in consumer harm.</p> <p>Additionally, the private marketplace, through industry and consumer group collaboration, can work together to ensure consumers fully understand their data rights, including how lenders will use their data, before they consent to sharing them.</p> <p>The use of alternative data will enhance the affordability of credit and make our credit system more inclusive. While policymakers should remain vigilant, they must also stay open‐​minded about how to encourage further developments in market innovation that will benefit consumers, small businesses, and the economy at large.</p> <p>I appreciate the opportunity to comment on this important hearing.</p> </div> Tue, 23 Jul 2019 16:42:58 -0400 Dan Quan https://www.cato.org/publications/testimony/examining-use-alternative-data-underwriting-credit-scoring-expand-access Financial Inclusion: The Cato Summit on Financial Regulation — Panel II: Uses without Abuses of Consumer Data https://www.cato.org/multimedia/events/financial-inclusion-cato-summit-financial-regulation-panel-ii-uses-without-abuses Wed, 12 Jun 2019 10:39:00 -0400 Tracy Basinger, Rob Morgan, Steven Smith, Dan Quan, Colin Wilhelm https://www.cato.org/multimedia/events/financial-inclusion-cato-summit-financial-regulation-panel-ii-uses-without-abuses