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Regulating Credit Scores: When Good Intentions Make Bad Policy

In previous posts, my colleagues have expressed concern over well-intentioned government proposals that seek to effect social policy by tinkering with the FICO® Score. Such actions threaten to diminish the predictive power of a risk management tool used by most lenders. This presents potential problems for both banks and consumers who may ultimately be impacted through higher rates and reduced access to credit.

Consider the case of a bill proposed recently in Montana. This legislation was intended to help consumers who were shopping for a mortgage, auto, student, or equipment loan, so that their credit score would not be harmed by multiple lender inquiries. The bill would have created a state law to require FICO to change its scoring logic to bypass all mortgage, auto or student loan inquiries in the last 30 days to 45 days.

This proposed outcome is not so different from what actually happens now with the FICO® Score when a consumer is shopping for credit. For quite some time, FICO Scores have used sophisticated logic to account for rate-shopping behavior. In fact, all mortgage, auto and student loan inquiries (but not “equipment loans”) that occur 30 days prior to scoring have no effect on the FICO Score. A recent blog post discussed the score’s rate shopping logic.

So why was the Montana legislation a problem? Because any change to the FICO® Score model has serious repercussions for lenders and consumers alike. Banks rely on the FICO Score as an objective, empirically derived risk management tool to help them accurately assess credit risk. They know that the development of FICO’s credit scoring models is a data-driven process, and that the predictiveness of the tool will be compromised when policy proposal mandate changes to the model without any analysis of whether the data supports the mandated changes.

The Montana bill also posed an additional problem of creating new operational costs for lenders. If adopted, the legislation would have required banks to use a Montana-specific scoring model when Montana residents seek credit while in-state or out-of-state. By making this change to the FICO® scoring logic, some banks might be forced to re-validate the new Montana FICO scoring model against their own portfolios. And if the Montana legislation were adopted, other states might follow its lead by imposing their own tweaks to the FICO scoring model. The impact on national lenders would be significant.

Consumers would also be negatively impacted if the operational challenges facing banks result in delays and higher costs, or, worse, cause some lenders to stop offering credit products in this relatively small consumer market. And if the FICO® Score became a less predictive underwriting tool, lenders would be more hesitant to extend credit to marginal borrowers.

Attempts to effect social policy by manipulating credit scores not only hinder the ability of banks to effectively assess credit risk. They can also result in many creditworthy borrowers being denied access to credit, or borrowers being extended more credit than they can safely handle.

The Montana problem was ultimately averted as FICO, banks, credit unions, retailers and credit bureaus convinced legislators in the Montana House of Representatives to table the bill. The message that the entire industry must continue to communicate in cases like these is that there are other, better ways to effect public policy changes.

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