24 Non-Prime Times July/August 2016 nafassociation.com

Could a Potential Economic Downturn Lead to Broader Use of Alternative Data?

Alternative Data

Origination volumes in auto financ-ing have been high and steadily increasing in recent years. New

market entrants and more generous credit terms have created an intensely competitive environment. Now with concerns of a poten-tial economic downturn ahead, the smarter and more experienced auto financing sources are building a stronger foundation for their credit and loss management strategies.

One of the strategies often evaluated is the incorporation of alternative data in deci-sioning processes. The topic lands on most industry conference agendas, including the recent National Auto Finance Association (NAF)eventinPlano.Whiletherearemanyrisk management and financial incentives encouraging financial service providers to ana-lyze alternative data, a number of obstacles should be considered before a provider can determine if alternative data adds value and more importantly, where to source it.

Over the next several issues of Non-Prime Times, we’ll explore the obstacles to using alternative data in risk and/or portfolio man-agement. Let’s start with one of the most common obstacles.

“I am not sure how to effectively test and evaluate alternative data.”

For years, auto financing sources have used traditional credit reporting data and scores. Over the years, financial service providers began implementing custom scoring with traditional bureau scores used as one compo-nent of the model. The scores also serve as a benchmarking tool for portfolio comparisons for investors. These methods are tried-and-true underwriting disciplines they built their businesses on.

Today, however, these methods are coming into question as not being robust and com-prehensive enough to include all potential consumers looking to buy and finance new

andusedvehicles.Talkofalternativedata(notto be confused with alternative lending or marketplacelending)ornon-traditionaldatacan be heard all around, but most non-prime auto financing sources struggle to accurately assess the sheer amount of data available to them. By looking at the businesses currently enjoying the benefits of alternative data, we can learn how they generated a credible cost-benefit analysis.

The key to a successful analysis involves starting with a proper input file, creating a comprehensive data set and streamlining the list of potential alternative data providers to a manageable group.

Key components for the input fileFinancial service providers are wise to

create a single file for evaluating multiple data sources. By utilizing one file, providers can set a standard performance definition for measuring the impact of alternative data. In addition, a standard file removes the impact of seasonality and the confusion created by dif-ferences in performance across multiple files. A well-constructed data file should include the following:

•Relevantsamplesize–Moreisbetterwitha generous representation of applications that are funded or approved but not funded, as well as those that are denied. By including all types of application outcomes, financial service providers are better able to definitively measure the impact a data source offers.

•Performanceindicators–Financialser-vice providers who provide granular detail on performance of funded loans are better positioned to understand how ancillary data may have changed their decision. In addition, a service provider providing the status of loans may be able to better anticipate future trends.

A comprehensive data setTo best realize the value of any potential

data provider, it’s best to provide as much data as possible in the inbound data set. As an example, consumer stability data, information around a consumer’s address, phone number, e-mail address and the frequency of change within those fields, is highly predictive. If a financial service provider captures applicable data on a consumer, it should be included in the file.

Clear data test goals and objectivesWhen testing alternative data, it is incum-

bent on financial service providers to have theendgameinmind.Serviceprovidersaregenerally seeking to qualify more consum-ers, eliminate risk, improve acceptance, or risk adjust pricing. The better both parties (thefinancingsourceandthedataprovider)understand the task at hand, the more likely the objective will be met.

For example, in a recent data study, a credit card provider who sought to increase accep-tance by utilizing third-party data to qualify marginal consumers found that consumer presence in the vendor’s database resulted in a 58 percent increase in default. While that number was eye opening, it wasn’t the objective – and the financial service provider never acted on it.

MeasurementsCompanies that have successfully imple-

mented strategies utilizing alterative data have first calculated the impact on their risk opera-tions via several measurements.

Hit rate – Number of applicants who would have been present in the alternative data file at the time of application.InarecentconversationwithaCROofa

non-prime auto financial service provider, we were given the standard measure applied for presence of data sources, “Unless one in five of my consumers has a hit, I cannot seriously consider adding the cost of programming and integrating.”

Scott Brackin

nafassociation.com July/August 2016 Non-Prime Times 25

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Alternative Data

If the data source has an adequate cover-age then the requirement shifts to the utility of the data.

Disparity – Measure of how much lift is provided.

Even in the instance of high hit rate alter-native data sources, often including public record type services, disparity isn’t guaranteed. If a data source has near universal presence but offers minimal separation, there is only increased cost to implement and access the data service.

One non-prime auto financial service provider shared the results of a data test she conducted where consumers matched by the third-party service defaulted 300 percent more frequently than the general popula-tion. As earth shattering as that sounds, the alternative data only showed up in 2 percent of inquiries.

Impact – Measure of how implementing the data effects the entire operation.

While the process sounds simple, often the results are not clear.

A financial service provider recently con-ducting a data study on bank behavior found that while there was a relevant hit rate and the disparity of performance was profound, the ability to realize the potential savings was mitigated by the cost.

Implementationstrategy – The practical application of data.

Recently,aninstallmentfinancialserviceprovider shared that the results shown to him by a data vendor were “too good to be true.” When asked to clarify, he shared, “we were shown a huge savings potential but my CFO can’t see how we realize that if at the expense of so much loan volume.” The challenge for executives is that while they realize there is data available from sources outside the tradi-tionalCRAs,theyoftenareunabletocreatea live environment where the existing model works in concert with additional data sources.

Auto financing sources that successfully negotiate the implementation process do so by evaluating how they can identify upside opportunities, as well as, obvious declines within the framework of their existing

operation. For example, a non-prime auto finance company reduced its instance of first payment default by 50 percent in the ini-tial six months, but later realized additional value by utilizing positive trades as a means to separate consumers with equal traditional credit scores.

For the remainder of this series of articles, we will look into other common objections to the use of alternative data including legal and regulatory obstacles, the inability or lack of desire to report data, as well as technology and resource challenges.

We will also share past experiences of auto financing sources to provide some insight and success stories that will help readers figure out the easiest way to determine if alternative data has a role in their business and to what degree.Staytuned…

Scott Brackin is vice president, Auto Finance, for FactorTrust. Scott has more than 20 years of experience in the consumer credit industry. He is currently focused on providing innovative infor-mation solutions to automotive finance service providers to drive growth while managing risks.