The information on and investigation of the credit applicant is a very important tool in eliminating retail credit delinquency. The pre-granting step enables the bank to collect proper data that helps in making the right credit decision and avoiding adverse selection. These investigations can be done through a variety of channels, including:
There are two main external sources of information:
Credit bureaus work with both consumer credit and commercial credit. As per the International Finance Corporation (IFC), a credit bureau is an institution that collects information from creditors and available public sources on a borrower’s credit history. The credit bureau collects information on individuals and/or small firms such as information on credit repayment records, court judgments, and bankruptcies. The credit bureau then creates a comprehensive credit report that is sold to creditors to help them determine the credibility of the applicants for credit.
Credit bureaus differ from credit rating agencies such as Standard & Poor’s (S&P), Moody’s, and Fitch. The credit ratings agencies collect financial information on large companies, conduct detailed analyses of operations, finances, and governance of such companies. and then issue credit ratings.
Credit bureaus focus on creditors’ behaviour, with higher grades or percentages on credit repayment patterns and records. They rely on statistical analyses.
They are essential to the success of credit markets and serve as indispensable tools for financial institutions to operate their retail lending business. Credit bureaus help address the fundamental problem in financial markets known as “asymmetric information,” which means that the borrower knows the odds of repaying his or her debts much better than the lender. The inability of the lender to accurately assess the credit worthiness of the borrower contributes to higher default rates, which negatively affects the profitability of the lenders. This process helps creditors/lenders to avoid the adverse selection that is called the Lemon problem.
Lenders address this problem by investigating a borrower’s ability to repay and/or by requiring collateral to cover the loss in the case of a default. Requiring collateral is often problematic, especially in developing countries and particularly in the case of new firms, micro-entrepreneurs, and small and medium-size enterprises (SMEs), as they often lack significant assets for use as collateral. In addition, the costs to lenders of seizing and liquidating assets that were pledged as collateral can be significant and the process can take a long time.
The business model of consumer credit reporting consists of:
Historically, this model was applied to consumer reporting but the bureaus now include information on small-size loans to firms.