This post was adapted from remarks delivered at the CEI Summit in Savannah, Georgia.
Everyone understands the need for access to credit. No matter how well we budget, we occasionally come up short due to an unexpected circumstance or expense—a car repair, a sick pet, a friend’s wedding. All kinds of things pop up and disrupt our financial plans, and this can be a real problem for millions of Americans. For example, a survey from the Federal Reserve recently found that 4 in 10 Americans would not have enough liquid savings to cover a $400 expense. In those situations, it helps to be able to borrow from the future in order to pay for urgent expenses today.
Beyond the unexpected, however, it often actually pays to purchase goods or services that we can’t currently afford. Refrigerators, cars, or an education are products and services that provide an ongoing, future stream of benefits that we may not be able to purchase up front. In this way, buying consumer durable goods or services is similar to a capital investment for a business. It often makes more sense to buy a car now on credit and pay the loan off while you use the product, rather than to save up money for a car over a number of years while you take the bus. For example, a major reason why General Motors overtook Ford as the most popular domestic car manufacturer during the 1930s was that GM offered auto financing through the General Motors Acceptance Corporation, while Ford merely offered a layaway plan. It’s obvious which financing option is best for consumers.
What credit does is smooth out your consumption over time while also enabling you to make household capital investments. It can be thought of as a time machine, allowing you to move value from the future to the present or from the present to the future.
The problem, however, is that financial access is a paradox: those who can afford credit are those who need it the least, and those who need credit the most are the ones for which it is hardest to access.
Currently, 26 million Americans are considered “credit invisible” as they lack the prerequisite data points to build a credit score. That is, lenders lack the ability to adequately assess the credit risk of a consumer, meaning that consumers are reliant on typically lower quality services when they should be able to qualify for cheaper and better products. Further, 33 million Americans are either “unbanked” or “underbanked,” meaning that they have limited or no access to traditional financial services. This means that lenders do not find it profitable or prudent to serve this segment of the population.
When people can’t access the credit they need, they suffer in many ways. It could be as mundane as putting off a purchase by a couple of weeks, or as dramatic as defaulting on rent and being evicted. In a variety of ways, lacking credit deprives us of the opportunity to improve our lives. This is why financial access and inclusion is not only an economic imperative, but also a moral one: it allows us to think beyond that next paycheck and plan our lives in the way we choose.
Fortunately, new financial innovations can help solve some of these problems. Financial technology, simply put, is the application of new technology to the world of finance, a process that has been occurring for as long as credit has existed. Yet recent improvements in digital technology, such as increased computing power, cloud technology, and machine learning, have vastly expanded the potential of modern financial services. Fintech lenders, for example, can provide borrowers with much cheaper, quicker, and easier credit. They can also extend credit profitably to more people on much more flexible terms, often lending to depressed areas where no other traditional lenders operate.
The problem, however, is that regulation keeps getting in the way. There has been an enormous increase in financial regulation in the wake of the 2008 financial crisis. For example, the Credit CARD Act of 2009 limited the terms and conditions of subprime credit cards and the Durbin Amendment placed price controls on debit card fees. Further, the Dodd-Frank Act established a brand new regulatory monstrosity, the Consumer Financial Protection Bureau.
The CFPB in particular has gone after the consumer finance industry with a zero-sum mindset, believing that the only way to improve consumers’ lives is through stricter rules and more aggressive enforcement actions. What is particularly unfortunate, however, is that not only is a lot of the CFPB’s regulation harmful, but it is also unnecessary, as new financial innovations are solving a lot of the issues that concern regulators.
A great example is payday lending. Recently, the Bureau has made an effort to write punitive regulations governing the product (which we at CEI have vigorously opposed). And yet there’s a new fintech company called Dave that is doing a better job of improving consumers lives through innovation, rather than regulation.
Rather than a traditional payday lender, Dave is a subscription service that offers to advance you a loan of up to $75, interest-free, if you are at risk of overdrawing you account, for a mere $1 month. The Dave app integrates with your bank account, analyzes your spending patterns, and creates a budget for upcoming expenses. It then texts you a reminder if you’re spending too much and are likely to overdraw your account. If you happen to need a short loan to cover an expense that will overdraw your account, Dave will advance up to $75, which will then be deducted from your next paycheck—the same way a payday loan works.
No matter how many lawsuits the Bureau brings or regulations it writes, it can never create a better product, at a better price, delivered in a more convenient manner. It can never create a product like Dave. Where regulation merely takes away people’s choices, fintech actually provides more and better choices by being cheaper and easier to use.
Another aspect of fintech that has the potential to transform the economy is alternative credit scoring and underwriting methods. Credit bureaus have traditionally relied on a limited set of criteria when assessing how likely a customer is to repay a loan, such as loan payment history, the length and type of credit you have, and the amount of credit you use. But millions of Americans simply do not have such a history and are therefore credit invisible.
Without a formal credit history, people are either shut out from the credit system altogether or are offered worse options than they otherwise deserve, while lenders lose an opportunity to make a profitable extension of credit. What new developments in fintech promise to do is paint a fuller picture of consumers’ financial lives so that lenders can better assess the credit risk of a consumer.
With the advent of big data and machine learning, assessing a borrower’s credit risk has changed substantially. The types of information that can be included and have been shown to have a strong bearing on creditworthiness are things as mundane as your phone bill payments and educational attainment, to more unusual examples like your social media accounts and whether or not you include your full name in your email address. All of these new data points can be used to generate credit scores and allow lenders to profitably extend more credit to more people, potentially bringing new financial opportunities to over 20 million Americans.
While recent regulation of consumer credit and financial technology has been disheartening, there is hope that things are changing. The new leadership at the CFPB under Director Kathleen Kraninger, for example, is looking to dramatically turn things around, reforming a number of burdensome regulations while also taking a more levelheaded approach to enforcement.
One priority is to be more favorable towards innovation and competition—an express legal requirement of the Bureau. One new initiative is the establishment of a regulatory sandbox, which is a periodically relaxed regulatory environment for firms with innovative business models that may have trouble figuring out exactly what is legally required of them.
While the prospect of financial regulatory reform has been dim over the past decade, new technology and more free-market regulators are potentially turning a new leaf, promising to improve the financial lives of millions of Americans.