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The OCR Glossary

Credit Reporting

Rowena Olegario

Credit reporting is a mechanism for sharing information on borrowers. Typically, the reports focus on borrowers’ past behaviors, which lenders use to predict the likelihood of repayment. In the past, credit reporting relied on borrowers’ reputation—that is, hearsay about a borrower’s character and financial standing. However, in recent times, cheap computing power has enabled credit reporting agencies to aggregate borrowers’ payment records and apply algorithms to assess whether a borrower is worthy of credit. Today, borrowers’ payment records have largely replaced hearsay and letters of reference as the factors that determine creditworthiness. While credit reporting is typically associated with individuals, it is also compiled on corporations, thus potentially affecting a corporation’s reputation. This entry covers the historical context of credit reporting and the emergence of credit reports and credit scoring.

Credit reporting emerged as a solution to the problem of information asymmetry, which occurs because borrowers know more than creditors about their own willingness and ability to repay a loan. Traditionally, creditors overcame the problem of trust by relying on networks of kinship, fellow townspeople, or coreligionists, especially when credit transactions involved long distances or took a long time to complete. As trade grew to involve larger numbers of counterparties, mechanisms for sharing information began to appear. One early example in 18th-century London was the Society for the Protection of Trade Against Swindlers and Sharpers, a group consisting of retailers who alerted one another about customers who failed to pay their debts. In the United States, entrepreneurs Lewis Tappan and John Bradstreet set up credit reporting agencies in the 1840s to collect information on businesspeople, which they sold to wholesalers and other trade creditors. The American agencies were structured as profit-making ventures. Germany, another early adopter of credit reporting, had both mutual protection societies and for-profit credit reporting agencies by the 1860s.

Reliable financial information on businesses was seldom available. To compensate, U.S. credit reporting agencies evaluated business owners’ assets (primarily landholdings), business ability, and “character.” The testimonies of local merchants, bankers, and lawyers were especially prized. Credit reporters took seriously any rumors about overindulging in alcohol, gambling, or extravagant living. Equally, a reputation for being hardworking, thrifty, and punctual in paying debts boosted a person’s creditworthiness. The credit reporting agencies collected positive as well as negative information. Academic studies have confirmed that the collection of positive information allows individuals to build reputation collateral, which is particularly important for new or poor borrowers who have limited physical assets.

At first, the credit reports were structured as narratives, but in the 1850s, the Bradstreet Company pioneered the use of credit ratings, numerical designations that made it easier to compare borrowers. Credit reporters also began asking for financial statements more regularly. But even so, the agencies continued to produce narrative reports, and the ratings were still based largely on hearsay. When “credit men” became professionalized at the end of the 19th century, they lobbied to put credit reporting on a more scientific basis by collecting objective information such as payment histories. But until the advent of computers, there was only limited collection and sharing of this kind of data.

Credit bureaus that reported on consumers (rather than businesspeople) began operating in a number of U.S. cities during the 1870s. Some bureau reports consisted simply of blacklists, while others reported on missed payments, bankruptcies, mortgages, liens on property, marital status, and character. Sharing information across regions was limited until the 1960s, when technological innovations changed the nature of credit reporting. Large credit reporting firms such as Equifax began using mainframe computers to automate their files, making it easier to transmit credit data. They convinced the large banks, retailers, and credit card issuers to share their data on consumers. As a result, the credit reporting firms achieved universal coverage of consumers in the 1980s.

Credit scoring, another innovation, eliminated the labor-intensive work of assessing applicants. Modern credit scoring began in 1958, when Fair, Isaac and Company introduced the precursor to its proprietary FICO score. Large retailers, oil companies, and business credit card issuers soon began using credit scoring. Cooperation intensified between Fair, Isaac and the large credit reporting firms, as well as the Visa and MasterCard networks. Eventually, FICO became the generic name for all of the scores that Fair, Isaac developed for its many clients, and the scoring methods converged. The existence of a common system made it easier for lenders to assess applicants—and thus provide more loans. FICO received a further boost in 1995, when the government-sponsored entities Fannie Mae and Freddie Mac, which insure most American mortgages, began writing FICO into their proprietary software, literally embedding the score into the industry standards. When Standard & Poor, an agency that rates fixed-income investments, began using FICO in its analyses of mortgage-backed bonds, it incentivized lenders to incorporate the score into their models. By 2003, nearly all mortgage applications were using the FICO scoring system. FICO made it possible to quantify the riskiness of mortgages along a spectrum so that borrowers could be charged accordingly. This gave lenders the (over)confidence to venture into previously untouched areas such as subprime lending.

The wide usage of credit reports and credit scores made inaccuracies even more consequential for consumers. The U.S. Congress passed the Fair Credit Reporting Act in 1970, giving people the right to see the information in their files, be informed of any adverse actions against them, and correct misinformation. The act defined a credit report as information “bearing on a consumer’s creditworthiness, credit standing, credit capacity, character, general reputation, personal characteristics, or mode of living.” Due to the high cost of gathering some forms of information, the credit reporting agencies soon limited their reports to items that were easy to collect, such as payment histories. Partly out of a desire to guard their own reputations for reliability and fairness, the national agencies also dropped potentially discriminatory “lifestyle” details such as drinking habits and sexual orientation.

Lipartito, K. (2013). Mediating reputation: Credit reporting systems in American history. Business History Review, 87(4), 655–677.

Miller, M. J. (Ed.). (2003). Credit reporting systems and the international economy. Cambridge: MIT Press.

Norris, J. D. (1978). R. G. Dun & Co., 1841–1900: The development of credit reporting in the nineteenth century. Westport, CT: Greenwood Press.

Olegario, R. (2006). A culture of credit: Embedding trust and transparency in American business. Cambridge: Harvard University Press.

See Also

Credit Rating; Information Intermediaries; Reputation Capital

See Also

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