1.1 Definition of a Credit Bureau A credit bureau is an institution that collects information from creditors and available public sources o...
1.1 Definition of a Credit Bureau A credit bureau is an institution that collects information from creditors and available public sources on a borrower’s credit history. The bureau compiles information on individuals and/or small firms, such as information on credit repayment records, court judgments, and bankruptcies, and then creates a comprehensive credit report that is sold to creditors. Credit bureaus differ from credit rating agencies, such as Standard & Poors (S&P), Moody’s, and Fitch, which 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 smaller creditors, mostly concentrate on credit repayment records, and rely on statistical analyses of large samples of borrowers and not on in-depth analysis of individual companies. Credit bureaus are essential to the success of credit markets. They serve as indispensable tools used by financial institutions to support 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 does.
The inability of the lender to accurately assess the credit worthiness of the borrower contributes to higher default rates and affects the profitability of the financial institution. Lenders address this problem by investigating a borrower’s ability to repay and/or by requiring collateral to cover the loss in 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), which often lack significant assets for use as collateral. In addition, the costs to lenders of seizing and liquidating assets that were used as collateral can be significant and the process can take a long time. According to a World Bank survey,1 in most developing countries it takes one to two years to enforce a contract and costs around 20-40 percent of the cost of the debt. In extreme cases, for example in the Congo, it takes on average three years to enforce a contract and may cost up to 250 times the cost of the debt. Hiring investigators to check borrowers’ backgrounds is costly. Conducting in-depth background checks, while justifiable for larger loans, is not possible for small loans. The unavailability of information at a low cost restricts the ability of lenders to expand and profitably run retail lending operations.
Monitoring and screening borrower behavior offers an alternative strategy to reduce the problem of asymmetric information. Past behavior is an extremely reliable predictor of future behavior.For example, many countries commonly grant credit to a firm only after the firm has had an account with the bank for at least six months to a year, which allows the bank to observe the firm’s cash flow. Another alternative, the group lending approach, mostly used by microfinance institutions, allows lenders to provide loans to individual borrowers who, through participation in the group, have developed a credit history with the institution. Only then does the lender extend individual loans. In these examples the credit history of the borrower, sometimes referred to as “reputational collateral,” enables an individual or a firm to gain access to financing. Credit bureaus also rely on monitoring and screening of borrower behavior. Lenders share information accumulated through their lending operations with a credit bureau, which then disseminates it to other credit providers.This allows them to better assess credit risks based on a given borrower’s past payment behavior. Lenders, therefore, can make better informed lending decisions.
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