Alternative Credit Scoring in India

What are the limitations of Traditional Credit Scoring

While traditional credit scoring models work well for borrowers who already have an established credit profile, they do not accurately depict the financial situation of many potential borrowers.

Key limitations of traditional credit scoring systems are as follows:

1. Traditional credit scoring systems are based purely on past borrowing practices

1. Traditional credit scoring systems do not include the current income or cash flow of the borrower

1. Traditional credit scoring systems do not allow for individuals who do not have any previous formal credit

1. Traditional credit scoring systems do not give you visibility into the day-to-day spending habits of the borrower

Who is Most Affected by the Traditional Credit Scoring Systems?

Due to not being included in the credit bureau, these borrowers are commonly labelled as risky or unreportable, despite consistent financial behaviours like obtaining income and using banking services properly. 

Borrower segments that are affected by traditional credit scoring systems:

1. New borrowers with no previous credit

1. Self-employed individuals

1. Gig or freelance individuals

1. Small business or MSME owners

What is the need for Alternative Credit Scoring in India?

Several structural factors contribute to this gap in the Indian lending ecosystem:

1. Limited use of formal credit products

A significant percentage of both individuals and small businesses are not using credit cards or formal loans. This has resulted in borrowers who receive regular income and who use banks to receive their income being left out of the traditional credit scoring process, since traditionally credit bureau scores develop from the usage of these products.

1. High dependence on self-employment and informal income

A reliance on informal and self-employment as a primary source of income. Many in India’s labour force are self-employed or work for small businesses. Although their income may be steady, their income is not derived from their employer (due to the nature of being self-employed). Thus, it is considered an inconsistent income stream when it comes to traditional credit scoring.

1. Credit bureau scores not reflecting real financial behaviour

Credit bureau scores, although they capture previous borrowing behaviour, do not accurately reflect the financial management habits of individuals and micro and small enterprises (MSMEs) in their daily lives.

It is commonplace to have regular inflows of income, and to manage their finances in a way that allows them to spend responsibly while having enough cash on hand to meet their needs. These are elements of financial behaviour that traditional credit scoring does not measure.

Uses of Alternative Credit Scoring

The use of non-traditional credit scoring is helpful in overcoming challenges. For example, alternative credit scoring provides lenders with a way to look at additional financial factors associated with an applicant’s banking activity in determining eligibility for credit.

1. Uses Established Financial Information to Assess Creditworthiness

The use of a borrower’s banking information (e.g., bank statement, employment income) provides lenders with valuable information regarding the borrower’s financial record outside of prior credit history.

1. Provides a More Detailed Assessment of Repayment Capabilities

By analysing income patterns, spending habits, and consistent cash flow, lenders can assess an individual’s repayment capabilities rather than just using their history of credit performance as the basis for underwriting decisions.

1. Expands Availability of Credit and Still Mitigates Risk

Through non-traditional credit scoring, lenders can serve new consumers and micro, small, and medium-sized businesses with additional financial data that allows the lender to determine credit risk using a more robust methodology based on data versus an individual’s credit history

Types of Alternative Data Used

Alternative credit scoring is a method of assessing creditworthiness using data that is not traditional but rather is continually being generated from the ongoing banking activities and transactions of a consumer.

How does Alternative Credit Scoring Work

There are a few typical steps to how alternative commercial data is used as the basis for assessing a potential borrower’s ability to repay. They are as follows:

1. Step 1: Borrower gives lenders permission to view their records

A borrower will not normally share their bank account history unless they explicitly give their permission for lenders to do so. In practice, however, most lenders will ask to review a borrower's transaction history on a regular basis. For example, when applying for a personal loan, a lender may request to see a borrower's bank statement for the previous 12 months.

1.  Step 2: Collect the alternative commercial data needed to complete the credit assessment.

Once a borrower gives their consent to the lender or the platform that they have chosen, they will provide the lender or platform with their bank account transaction histories and other alternative commercial data in order to help determine their ability to repay.

1.  Step 3: Organise and categorise the commercial data

Once the lender or platform has received the alternative data from the borrower, the lender/ platform will then review the transaction history to determine the borrowers' income source, types of expenses, or any other expenses/obligations. The borrower’s bank account transaction history is now structured and organised into categories of income and expenses to provide the lender or platform with a clear and organised means of analysing the borrower's ability to repay.

Step 4: The analysis of financial behaviour

In this phase, analytical models will take the above structured data and look for key indicators of how the Borrower manages their finances, including:

1. Frequency and Consistency of Deposits - How regularly a borrower receives income.

1. Spending and Expense Patterns - The degree of regularity with which they make purchases, e.g. groceries, rent, utilities, etc.

1. Cash inflows versus outflows - The total amount of money coming into an account versus the total amount going out (which is the ratio of money in and out).

1. Overall Stability of Cash Flow -The estimated amount of money remaining in the account after paying all the above expenses.

1. Step 5: Assessment of repayment capacity

Lenders will review the borrower's capacity to repay indebtedness using behavioural analysis. Demonstrating a stable source of income, limiting expenditures, and demonstrating positive cash flows indicate less risk to the lender from a credit perspective, even if the borrower has no historical credit.

1. Step 6: Generate risk insights

The data collected through analysis provides lenders with actionable risk insight by indicating the strengths and weaknesses of a borrower's financial standing, enabling them to make more informed underwriting decisions.

1. Step 7: Credit decision support

Behavioural analysis allows lenders to make faster, more accurate decisions than relying solely on traditional bureau data. Because behavioural analysis is based on the borrower's current financial behaviour, lenders are able to make quicker and more accurate credit decisions than through the traditional bureau approach.

1. Step 8: Outcome for lenders

The credit assessments are accessed quickly. There is more transparency with respect to a borrower's finances. Thus, credit decisions are derived from real financial behaviour.

Alternative Credit Scoring versus Credit Bureau Scoring

The following table addresses the differences between Alternative Credit Scoring and Credit Bureau Scoring:

Advantages of Alternative Credit Scoring

Alternative credit scoring provides benefits to lenders and borrowers alike by moving away from the traditional, historical means of assessing a potential borrower's creditworthiness and toward an assessment system that assesses actual behaviour when managing their finances.

Lender Benefits

1. Greater Risk Insight: Using alternative credit scoring allows lenders deeper insight into their prospective borrower's financial situation through analysis of bank transaction data, income flows, and cash flow habits. As a result, lenders are less likely to rely on outdated or missing information from credit bureaus.

1. Access to a Broader Borrower Base: Alternative credit scoring enables lenders to serve thin-file and credit-invisible borrowers like solo entrepreneurs and micro, small and medium-sized enterprises (MSMEs) who've been unable to qualify for loans under traditional scoring systems.

1. Faster, More Efficient Decision Making: Investigating alternative data through automated analysis speeds up the evaluation process of the loan application compared to manual or credit-bureau only underwriting practices.

1. Improved Quality of Lenders' Credit Portfolios: By assessing clients through their behaviours as opposed to on historical credit information, lenders have an improved ability to correctly identify the creditworthy from the uncreditworthy, thus resulting in healthier credit portfolios and lower levels of risk.

Borrower Benefits

1. Greater Access to Formal Credit: Borrowers who do not have an established credit history may obtain loans by way of demonstrating their creditworthiness through financial behaviour.

1. More Fair Assessment of Borrowers Based on Behaviour: Alternative credit scores provide assessment of how borrowers manage their finances (e.g., keeping a budget and paying bills), as opposed to only giving them negative credit scores based on their lack of credit history.

1. Inclusion of previously excluded borrowers: Borrowers who have access to formal lending channels but have previously been rejected include new-to-credit individuals, self-employed professionals, and small businesses.