Why Card Lenders Need To Be Cautious Using FICO’s New Credit Score System

Earlier this month, analytics firm FICO announced plans to roll out a new credit score system that will allow card lenders to access the risk profile of roughly 15 million Americans who currently don’t have a FICO score. ^[1] The new system relies on alternative data provided by LexisNexis and Equifax to generate a credit score for people who have little or no credit history. This will allow lenders to target a new group of potential customers that are ineligible for credit cards and other loans under the current system.

The promise of new customers clearly grabbed the interest of the lenders, as 12 of the country’s largest card issuers have already signed up to use FICO’s new credit score system. But it will be important for the lenders to understand the inherent trade-off that exists with this new system. These customers present a higher risk of default and will add to the lenders’ charge-off rates in the long run. In this article, we highlight what one of the country’s largest card lenders – Capital One (NYSE:COF) – potentially gains and loses by using the new FICO credit scores.

See the full Trefis analysis for Capital One | JPMorgan | U.S. Bancorp | Wells Fargo | Bank of America | Citigroup | American Express | Discover

Over recent years, credit card issuers across the country have pushed their card offerings harder as they look for ways to nullify the negative impact of increased regulatory oversight and low interest rates on their card revenues. Credit card loans are arguably the most lucrative of the loans in a bank’s portfolio because of the high interest rates that they demand – something that more than makes up for the unsecured nature of this credit line. However, the intense competition among incumbents in the industry has seen them relaxing their lending criteria to be able to grow their customer base. This is evident from the fact that the FICO credit score threshold has been reduced from 650 to 620 by almost all these lenders in recent years.

But this credit score system suffers from an important flaw – it does not include American citizens who do not have sufficient credit histories. While the current scoring system applies to nearly 200 million people, there are roughly 53 million people who don’t have a FICO credit score. ^[2] The newly proposed FICO credit score system will make the alternative credit score of as many as 15 million additional people available to lenders by using a large set of data, including an individual’s past record in terms of paying cable, phone, electric and gas bills, among others.

The new system definitely holds merit, as it provides lenders a tool to identify the risk profile of potential customers. This in turn will be beneficial to the lenders in two clear ways: firstly, the addition to their customer base will help boost growth in their card balances. And secondly, as these customers are ineligible for cards and loans under the traditional credit score system, the lender can impose higher fees and interest rates on them. But on the downside, these customers are much more likely to default on their loans. This will add to the lenders charge-off figures and will also force them to incur higher personnel-related costs linked to collections and recoveries.

So what exactly would the net impact of this be on a particular lender? We sought to answer this question for Capital One. We chose the card-focused bank as it would be easier to understand the effects of changes in card portfolio on this company’s overall value compared to its significantly more diversified competitors like JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) or Citigroup (NYSE:C).

We currently estimate a 4% annual growth in card balances for Capital One in the long run (shown in the chart above). Now let’s suppose that the adoption of the new credit score allows it to grow these balances by 6% in the future. Also, the higher interest rates on newly added cards would justify an increase in Capital One’s card yield from our current forecast of under 13.2% to a figure above 13.5%. The combined effect of these changes would add roughly $3 billion in value to Capital One – a 6% upside to our current estimate.

But as you can see by making changes to the chart below, if Capital One’s charge-off rate increases as a result of the new policy to 4.5% by the end of our forecast period instead of the 4% we currently estimate, then the entire $3 billion upside is eliminated. Considering the fact that credit card charge-offs have been unusually low over recent months owing to the brisk pace of economic recovery and the billions in loan provisions lenders have released, a charge-off rate of 4.5% for Capital One in the near future is not at all far-fetched. It would therefore appear that lending to the riskier customer base unlocked by FICO’s new score system presents a bigger downside to Capital One than the potential value it adds. We believe that this will hold true for most card lenders.

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1. FICO, LexisNexis Risk Solutions & Equifax Joining to Generate Trusted Alternative Data Scores for Millions More Americans, FICO Press Releases, Apr 2 2015 [↩]
2. FICO Creates New Credit Metric for Risky Consumers, The Wall Street Journal, Apr 1 2015 [↩]