What's in the File? the Economics and Law of Consumer Credit Bureaus

Article excerpt

Consumer credit bureaus are organizations that compile and disseminate reports on the creditworthiness of consumers. (1) Firms that lend to consumers provide the underlying data to the bureaus. In the United States today, there is at least one credit bureau file, and probably three, for every credit-using individual in the country. Over 2 billion items of information are added to these files every month, and over 2 million credit reports are issued every day (see Consumer Credit Bureaus in the U.S.). In many instances, real-time access to credit bureau information has reduced the time required to approve a loan from a few weeks to a few minutes or even seconds.

In this article, I examine the information problems lenders encounter when making loan decisions and how information-sharing--through institutions such as credit bureaus--can mitigate these problems. I then explore some of the factors that influence whether lenders will agree to share their information and credit bureaus' incentives to maintain accurate credit report files and to correct them when errors are found. With these insights in mind, I will examine the system of regulation adopted to safeguard privacy and improve the accuracy of credit bureau files. Finally, I'll review some of the challenges the industry faces in the first years of the 21st century.

THE ECONOMICS OF INFORMATION SHARING

Lenders encounter two problems in conducting their business. The first problem, adverse selection, occurs when borrowers are not all the same--they have different characteristics that affect the likelihood they can repay their debts--but lenders cannot always tell them apart. In this situation, lenders will offer terms that depend on the average risk of default. Since riskier borrowers are more likely to default anyway, this raises the cost of a loan disproportionately for the borrowers most likely to repay. Hence the customers most likely to produce an adverse outcome--defaulting on a loan--are the ones most likely to accept the less attractive loan terms. (2)

The second problem, moral hazard, occurs if once a loan is made, a borrower would benefit by defaulting on the loan. More generally, a borrower may not take sufficient precautions to avoid default. Lenders try to design loan contracts to deal with this problem, but that's not always possible. In that case, lenders will lend to fewer borrowers, in smaller amounts, and on harsher terms.

Sharing information about borrowers' characteristics and payment histories can mitigate these problems. Armed with more information, lenders can better evaluate potential borrowers and offer loan terms commensurate with their risk of default. And if future access to credit is a valuable option to a borrower, he or she will have an incentive to avoid a default that might become known to other creditors.

Lenders could share information about their borrowers by simply sending it to every lender willing to reciprocate. But it is clearly more efficient for lenders to send this information to a single repository, which can make the information available to other lenders when they need it. Such repositories are the credit bureaus we have today.

BUT DO CREDIT BUREAUS JUST HAPPEN?

Should we expect credit bureaus to emerge as a natural response to the self-interest of creditors? The answer is often yes, but not always. (3) Economic analysis suggests a variety of factors can influence the formation of credit bureaus.

Technology and Market Size. One important factor is the cost of establishing and operating an information-sharing regime. These costs may be prohibitive if fixed costs are high and relatively little lending is going on. But if loan volume is sufficiently large, the costs can be amortized over many loans. In the U.S., advances in computing and telecommunications have reduced the marginal cost of sharing information but increased fixed costs because of the required investments in information technology. …