Credit reporting companies serve as sources of information about consumers' use of credit as reported by those from whom consumers borrow. Lenders use this information to supplement whatever data they have already directly acquired about a borrower's creditworthiness to make lending decisions. As part of this system, lenders have incentives to report their own experiences with borrowers so as to gain access to other creditors' data in the future.
The credit data essentially represent a consumer's credit "reputation," based as it is on his or her borrowing and repayment behavior over time. In the past, this "reputation" was usually maintained by lots of local agencies working with local lenders with incomplete and often unverifiable information. Today, regulation and consolidation have led to highly automated national firms that compile far more detailed and complete information and comply with a range of policies designed to protect the interest of consumers.
Credit reporting companies give businesses insights into a consumer's past behavior, similar to the ways in which an insurance company might use a driving record or a prospective employer might use a college transcript. These insights, which include a consumer's record of meeting financial obligations, can be used to make decisions about his or her stability and his or her ability and willingness to repay debt. Without such information, borrowers would likely be required to provide far more information about themselves when applying for any type of credit and pay more for access to credit. In fact, in countries that do not have a well-developed credit reporting system, creditors can make the mistake of lending to consumers who are already overextended or in default with another creditor. These mistakes result in a higher cost of borrowing for all consumers.
In his article "What's in the File?" economist Robert M. Hunt explains the importance of credit reporting. He writes: "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." So in addition to providing creditors with the information necessary to properly measure risk, credit reporting companies provide incentives for consumers to use credit responsibly. For these reasons, credit reporting companies play an important role in the efficient allocation of consumer credit.
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