From my experience both as a technical expert on credit risk as well as personal experience, credit score is an outdated system. Credit score is a one-dimensional view of a person’s financial health. The gap between what it does and is used for creates opportunities for lenders and other institutions to up-skill their data and analytics for offering better credit services for our time.
Although most of my experience in credit risk is more in Commerical lending rather than personal, I had researched and developed retail credit risk models for a book that I have been writing. The data I used was actual Lending Club data. Fico score is not unimportant, but it was not among the top predictors.
Let me start with my personal experience: several months ago, I opened a premier type of account that requires substantial balances but promises international access. My credit score was printed in the first letter from the bank. I was neither interested in nor requested a credit card. But I guess I did not disagree when I was offered the metal card. To my surprise, my credit score was below average.
Months after, this below-average score is still nagging me inside. I just have to write something about it.
1. Concentration risk: Ninety percent of the money that the company made was from China (and Hong Kong). Concentration risk is not necessarily a bad thing. However, it becomes a problem when this is in direct conflict with other risks, such as geopolitical risk. Furthermore, concentration in reveue sources such as traditional lending exposes the bank to interest rate risk in a near-zero interest rate enviroment in the US, UK, and Europe.
2. Geopolitical risk: Headquarter in the UK but had operations in over 100 countries. Brexit, Hong Kong unrest, unsettling relationship between countries all contribute to uncertainties of its operations and profit.
3. Regulatory risk: The regulatory risk associated with geopolitical risk means that the bank must follow rules of the PRA (UK) in all locations in addition to local regulatory bodies, such as OCC-Fed-SEC in the US. The bank was fined heavily in the US due to poor AML compliance and had to scale down business dramatically, resulting long-term loss of customers, businesses and reputation.
4. Acquisition risk: If some other risks are out of a company’s control, this one should have been taken care of within control. Mistakes in acquisition can be very costly (tens of billions of dollars in write-down) and can weaken a company significantly. Large acquision without real understanding of the downside risk, and on top of that, fire sell aquired assets during market downturn lead to huge losses of money and customers.
After Thoughts
Two of my favorite investors, Sam Zell and Howard Marks, both have said that understanding risk is the most important thing in their investment strategies. Sam Zell even put it this way: you need to fear, to be respectful of risk.
Here is what Sam Zell said in a podcast:
You had to be realistic. You had to be able to look at it and say, “What could go wrong?” If I learned anything from [Jay Pritzker], I learned that if everything went too well, you could survive. The only time you couldn’t survive is if it didn’t go so well.
So focusing on the upside was interesting, but not productive. Focusing on the downside was what risk was all about.
And to the extent that you could quantify the downside—to the extent that you understood what the risk was you were taking—your chances of survival were much better…. I think a lot of people get in a lot of trouble because they do a transaction and they don’t understand what the risk they’re assuming is when they do the transaction. And what he taught me more than anyone else was [to] look at the deal and figure out: Where is the vulnerability? Where is the assumption you’ve made that has to be right in order for the deal to work?