The New Lending System - Putting common sense into compliance and risk assessment

Yesterday, the conference coordinator for an external event where I soon will be speaking asked me if the new lending system I have been advocating would surpass the FICO Credit Score. In our latest book, published in April 2009 by John Wiley & Sons, Sunny Zhang and I make the case that we need a new singular measure of creditworthiness. In our view, the FICO Score is an incomplete, inaccurate and out of context risk measure that focuses only on how consumers have paid their credit obligations in the past without regard for prevailing, and anticipated, circumstances, their income, savings, and a host of other factors. More specifically:

FICO is a one-size fits all technology that is also a black box, i.e. consumers are not told what characteristics are included in their score and how many points they were assigned for each of those factors. Consumers do not even know how specifically to improve their FICO Credit Score! While it is true that credit scoring is more consistent that a purely judgmental system of credit granting, it is rooted in models that attempt to identify statistical correlations between “substitute factors” and poor loan performance. Many of those substitute factors have no direct logical connection to loan default or are viewed out of context, in stark contrast with such factors as capital and capacity. Consequently, when we experience significant change, such as the current economic downturn, FICO scores become irrelevant (i.e. what used to be predictive no longer is).

CCAF (pronounced See-Caf) is rooted in common sense and the basic guiding principles of credit granting, namely the 5 C’s of Credit – Character, Capacity, Capital, Collateral, and Conditions. CCAF first classifies borrowers holistically before assessing their risk. Hence, their CCAF score is in the proper context, and it considers all relevant factors. Furthermore, an importantly, CCAF is transparent in that borrowers can decipher how they rated on each of the factors considered during the evaluation of their loan application, and how they can boost their creditworthiness.

I was so thankful that the question was raised, comparing CCAF to FICO. Yes, the FICO score falls far short of meeting today’s credit market demands for greater relevancy, accuracy, and transparency throughout the lending value chain, i.e. borrowers-to-lenders-to-securitizers-to-investors! Replacing FICO with CCAF would enable borrowers to better balance product options and loan affordability, lenders to more effectively balance loan volume and quality, and investors to better balance risk and return. CCAF adoption will help prevent future financial crises and can also help deal with the fallout, namely loss mitigation and foreclosure avoidance.

In our research for our book, Sunny and I concluded that a couple of root causes of the current financial crisis were inadequate risk assessment and lack of transparency. The secret sauce, narrow, and historical-behavior based FICO Score is used pervasively throughout our credit system, and it was most certainly one of our critical risk measurement antennae that was fully extended when the financial time bombs and loan default missles hit our financial system. It appears that at least one other of our critical risk measurement antennae was, at the same time, severely retracted, namely common sense! CCAF adoption will provide a far more powerful and much needed risk antennae for borrowers, lenders, investors, and regulators and it will automatically go a long way to fully extend the common sense antennae!