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June 2nd 2023

Is the Lending Industry Ready for Alternative Data?

Sarah Davies

It’s been a tumultuous couple of years for lenders. With a looming recession causing economic instability and aftereffects of the pandemic continuing to influence consumers’ financial health, lending to mainstream consumers has been under a spotlight. Add in the disruption from emerging technology in the space like Buy Now, Pay Later (BNPL) products, and lenders have a perfect storm of variants. 

These are seemingly just the outputs of a changing world – one that lenders struggle to keep up with due to the foundation they were built on. Whereas for consumers, change is what fuels innovation. Transformations in technology such as Web3 and open banking have empowered consumers to take back ownership and control of their data footprints more than ever before. 

Could change be in the air for lenders when it comes to data, too? While only time will tell, we are at a very important crossroads for this conversation as more lenders question whether traditional credit reports, which for decades have been the primary data source for evaluating risk, are the most efficient and accurate tool for evaluating a consumer’s holistic financial picture. Not only do these reports leave sizable gaps and sometimes sizable mistakes, but they also limit opportunities for lenders to reach large portions of the population who don’t use credit frequently or in conventional ways. Just in the U.S., more than 50 million consumers fit this bill and are deemed “credit excluded.”

Alternative data is not a “new” conversation by any means in the world of lending. Different forms such as income verification, payday loans, bank transaction data, and cash flow underwriting have been around for some time. However, over the past few years, alternative data has picked up steam as more lenders have increasingly tapped these alternative data sources to get beyond what’s laid out in credit reports. 

Present: alternative data in underwriting

Change is in the air when it comes to traditional credit underwriting. In October we saw the Federal Housing Finance Agency (FHFA) approve two new credit score models for use by Fannie Mae and Freddie Mac, two of the largest home mortgage companies. Not only will this improve access to mortgages for millions more creditworthy consumers, but this also signals a shift in the lending industry. More traditional lenders are looking towards looking at a broader range of evaluation data to better understand the full picture of the risk to cultivate a more inclusive approach in the industry and improve accuracy for credit risk assessment. 

Lenders agree that the data currently used in underwriting processes is lacking. According to Nova Credit’s report on The State of Alternative Data in Lending, 75% of those surveyed believe that traditional credit data and scores don't deliver the complete picture. To get ahead of this, 59% have already turned to using forms of alternative data in their underwriting process, with employment/income verification, non-transaction checking account data, and cash flow/bank transaction data being the three biggest sources. 

Telecommunications or utility data, rent payments, and payday data also provide valuable insight into a consumer’s trustworthiness and where they seem to perform well. However, the value of this data comes back to what it is paired with and how it is ranked. For example, if consumers also have a mortgage, vehicle loans, etc., their ability to pay a $40 utility bill doesn’t mean much in the bigger picture. It’s up to lenders to tailor their underwriting strategies to these variables and rank them accordingly. 

Market perception and barriers to adoption

While the original fabric of credit scoring within our financial system here in the U.S. was established over three decades ago, the industry is finally on the precipice of another major change. When asked about their perception of where the industry is today in regard to the adoption of alternative data, 50% of lenders in Nova Credit’s survey say the industry is ready. Among the 17% who feel the industry is not ready to adopt, this sentiment was changed if the industry was able to better validate its impact on predictability. Like any new technology or process, this concern is not surprising and likely to sway as more organizations can demonstrate alternative data’s effectiveness and spread the word. 

The top apprehensions to alternative data tie back to the reliability and/or stability of the data and any associated costs with integration/analysis. While those reservations are reasonable, lenders also need to consider the growth opportunities that can counteract those costs with the ability to engage previously overlooked consumers. Ninety percent of those surveyed agree that alternative data has the potential to help them gain access to a larger audience. 

The looming recession’s impact 

As the industry prepares for a possible recession, many lenders are re-evaluating their risk strategies. In fact, 56% of surveyed lenders foresee changes to their credit risk policies in the next twelve months. This creates an appealing time for alternative data as more lenders seek out enhanced toolkits to manage growth without taking on any added risk. Different forms of alternative data, such as cashflow underwriting, provide direct insight into what’s in a consumer’s bank account and the availability of funds for paying any future responsibilities, such as a loan. 

With the recession in mind, a third of surveyed lenders reported that they will continue to adopt alternative data into their underwriting over the next year. Armed with this more complete data profile to make smarter decisions, these lenders will be well positioned to grow despite the economic climate versus those that choose to sit on the sidelines and wait it out. 

The next twelve months will be a transformational time for the lending industry and will set the stage for the next phase of alternative data in lending. As in any industry, lenders need to be on the forefront of innovation and come to terms with outdated underwriting processes. This means embracing more data sources to improve predictably, reach new customers, and drive forward a more fair and inclusive credit reporting system.

Announcing the Cash Flow Underwriting Summit: a first-of-its-kind executive summit dedicated to exploring and advancing the practice of cash flow underwriting in consumer lending.