What is credit reporting?

52.11 Credit reporting involves providing information about an individual’s credit worthiness to banks, finance companies and other credit providers, such as retail businesses that issue credit cards or allow individuals to have goods or services on credit. Credit reporting is generally conducted by specialised credit reporting agencies that collect and disclose information about potential borrowers, usually in order to assist credit providers to assess applications for credit.

52.12 Credit reporting agencies collect information about individuals from credit providers and publicly available information (such as bankruptcy information obtained from the Insolvency and Trustee Service Australia—a federal government agency). This information is stored in central databases for use in generating credit reporting information for credit providers. In assessing credit applications, this information augments information obtained directly from an individual’s application form and the credit provider’s own records of past transactions involving the individual.

52.13 Credit reporting agencies also provide information processing services that assist credit providers to assess credit applications. One agency, Veda Advantage, stated that:

Statistical modelling of individuals’ behaviour over significant timeframes has enabled Veda Advantage to provide its customer base with the credit file characteristics which are statistically relevant to the probability of default. Customisation of these credit file and behavioural characteristics by each subscriber is based on the particular risk model, portfolio and competitive positioning.[7]

52.14 The information contained in credit reporting databases may be used in credit scoring systems. Credit scoring may be described as the use of ‘mathematical algorithms or statistical programmes that determine the probable repayments of debts by consumers, thus assigning a score to an individual based on the information processed from a number of data sources’.[8] In Australia, credit scoring systems used by individual credit providers are often referred to as ‘scorecards’.

52.15 As Professor Daniel Solove explains, credit reporting is an understandable response to a modern, interconnected world containing ‘billions of people’ and where ‘word-of-mouth is insufficient to assess reputation’. He goes on to state:

Credit reporting allows creditors to assess people’s financial reputations in a world where first-hand experience of the financial condition and trustworthiness of individuals is often lacking.[9]

52.16 The role of a credit reporting agency is to provide rapid access to accurate and reliable standardised information on potential borrowers. Such information enables credit providers to manage the risks of lending and to guard against identity fraud. Economic theorists note that:

Credit reporting addresses a fundamental problem of credit markets: asymmetrical information between borrowers and lenders that leads to adverse selection and moral hazard.[10]

52.17 Information asymmetry refers to the fact that, because a credit provider often cannot know the full extent of an applicant individual’s credit history, the individual has more information about his or her credit risk than the credit provider. Adverse selection arises where a credit provider, operating in response to information asymmetry, prices credit based on the average credit risk of individuals. This creates an incentive for high risk applicants to apply (the price is low to them) and low risk applicants to reject credit (it is overpriced for them).

The result is adverse selection because the client group the credit provider ends up with is a higher risk than the credit provider priced for. Better information allows credit providers to more accurately measure borrower risk and set loan terms accordingly, which is why credit providers maintain their own databases of information on a consumer but also seek out information shared by other credit providers and supplied to them by a credit reporting agency.[11]

52.18 Information asymmetry also creates a moral hazard. A credit applicant may obtain credit fraudulently by failing to disclose his or her credit history. Credit reporting reduces such moral hazard because non-payment to one credit provider can inform the actions of other credit providers.[12]

52.19 While the major purpose of credit reporting is to provide information to assist credit providers to assess applications for credit, credit reporting also may be seen as serving the associated purpose of facilitating responsible lending. That is, the information provided by credit reporting to credit providers may help to prevent individuals becoming financially overcommitted. Credit reporting also assists in trade and mortgage insurance, and in debt collection.

[7] Veda Advantage, Submission PR 272, 29 March 2007.

[8] F Ferretti, ‘Re-thinking the Regulatory Environment of Credit Reporting: Could Legislation Stem Privacy and Discrimination Concerns’ (2006) 14 Journal of Financial Regulation and Compliance 254, 261.

[9] D Solove, ‘A Taxonomy of Privacy’ (2006) 154(3) University of Pennsylvania Law Review 477, 507–508.

[10] M Miller, ‘Introduction’ in M Miller (ed) Credit Reporting Systems and the International Economy (2003) 1, 1.

[11] Consumer Affairs Victoria, The Report of the Consumer Credit Review (2006), 247.

[12] M Miller, ‘Introduction’ in M Miller (ed) Credit Reporting Systems and the International Economy (2003) 1, 1.