Recent research found that algorithmic scoring in fintech is reducing discrimination in lending
Discrimination is weaved into the fabric of most societies throughout the world, Of course, the United States is no exception.
Discrimination is not just a personal flaw. It is an institutional flaw as well. Institutional discrimination is the unjust and discriminatory mistreatment of an individual or group of individuals by society and its institutions as a whole, through unequal selection or bias, intentional or unintentional; as opposed to individuals making a conscious choice to discriminate.
While not often discussed, institutional discrimination is pervasive in the United States in both subtle and not-so-subtle ways. One of the obvious ways that institutional discrimination manifests itself is in the justice system in the form of the over representation of African American males in jail.
Law as a tool to protect from discrimination
Society’s response to both personal and institutional discrimination has been the passage of laws intended to protect the rights of discriminated groups within society. Laws such as the Civil Rights Law of 1964 are intended to protect individuals from discrimination based upon race, disability and economic status.
Laws have also been passed to protect individuals and groups of individuals from discrimination by industry. The Fair Housing Act of 1968 protects people from discrimination when they are renting or buying a home, getting a mortgage, seeking housing assistance, or engaging in other housing-related activities.
Despite the passage of such laws, personal and institutional discrimination persists across all facets of society. Some would argue that it has in fact increased in recent years.
Technology as a tool to protect from discrimination
Technology and specifically the Internet has been around for 30 years now. It has affected every facet of our global society ranging from the way we communicate, engage in commerce, and govern. History will eventually judge whether these are positive or negative impacts upon humanity.
One way in which technology is having a positive impact is in the reduction of institutional discrimination within the lending industry in the United States.
Technology reducing discrimination in lending
Discrimination in lending can occur in face-to-face credit decisions or in algorithmic scoring. Consumer-lending discrimination in the Fintech Era by Bartlett, Morse, Stanton, and Wallace estimated the extent of racial and ethnic discrimination by looking at the pricing of mortgage credit risk. Using rigorous statistical analysis of loans packaged by Fannie Mae and Freddie Mac, the study authors were able to determine the additional cost that a borrower paid as a result of being discriminated again.
Fannie Mae and Freddie Mac are government-sponsored buyers of mortgages from lenders who then package and resell them as mortgage-backed securities. While the study looked and mortgage lending practices, the findings are applicable to other forms of debt products such as consumer loans and auto loans.
There are two ways in which a borrower engages with a lender; face-to-face decisions or in algorithmic scoring. Face-to-face decisions are based on the borrower’s credit score and are based on a personal relationship with a banker from the lending institution. In contrast, algorithmic scoring automates the underwriting function that would traditionally be done by a banker.
Despite the existence of laws such as the Fair Housing Act of 1968 that are designed to eliminate discrimination in mortgage lending, discrimination persists. In face-to-face decisions, the study found that lenders charge Latin American and African American borrowers 7.9 and 3.6 basis points more for purchase and refinance mortgages respectively, costing them $765 million per year in additional interest. Fintech algorithms also discriminate, but 40% less than face-to-face lenders.
These results are consistent with both fintech and non-fintech lenders extracting monopoly rents in weaker competitive environments or profiling borrowers on low-shopping behavior. Such strategic pricing is not illegal per se, but under the law, it cannot result in discrimination.
The lower levels of price discrimination by algorithms suggest that removing face-to-face interactions can reduce discrimination. Further silver linings emerge in the fintech era:
- Discrimination is declining: algorithmic lending may have increased competition or encouraged more shopping with ease of platform applications.
- 74-1.3 million minority applications were rejected between 2009 and 2015 due to discrimination. However, fintechs do not discriminate in loan approval.
Fintech is revolutionizing the financial services industry. Amongst some of its many benefits are reduced costs to consumers, banking of the unbanked, down market access to new services and many more. An additional unexpected benefit to fintech is the reduction of discrimination in the lending process.
Zip Capital Group is a fintech company focused on helping small businesses use merchant cash advances to meet their business needs and funding goals.