Why banks are struggling to assess creditworthiness during the coronavirus pandemic

It's no secret that banks tighten their approval standards when the economy is in a recession, as well as taking steps like lowering customers' credit limits to reduce their overall risk and exposure.

While the ongoing coronavirus pandemic has pushed the U.S. into its third recession of the millenium (following the dot com crash in the early 2000s and the mortgage crisis of 2008), the speed at which things turned south and the sheer number of people affected make this time different. In particular, banks are struggling to determine whether applicants are actually creditworthy.

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Unintended consequences

A new report by the Wall Street Journal highlights a number of problems that were intended to help consumers navigate this difficult time, but are now making it harder for applicants to be approved for new lines of credit, including credit cards, personal loans and car loans.

The first issue is a provision of the CARES Act, the government's coronavirus stimulus bill, that says that lenders that allow customers to defer payments can't report these payments as late to the credit bureaus. Late payments are a very important risk factor for banks trying to decide who to extend credit too, and without that data, banks are struggling to figure out whether a potential applicant has lost their job or is behind on their existing debt.

Related reading: Issuers are cutting credit limits, but here's what you can do about it

Even if banks did have access to that data, it wouldn't necessarily solve the problem. Most major lenders are making payment deferral options available to all of their customers, whether or not they've lost their jobs or had their hours reduced.

For example, I was given the option to defer payment on my monthly health insurance premiums and credit card bills, even though I've continued to work throughout the pandemic. Deferred payments wouldn't necessarily separate the risky applicants from the safer ones.

Related reading: How to recession-proof your credit score

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What banks are doing

It's going to be much harder to get approved for new lines of credit until either the economy recovers or banks figure out a better way to analyze new applications. In the month of May, banks mailed roughly 74 million credit card offers to people's homes, down from more than 300 million in the months preceding the pandemic.

Of course banks have every incentive to find new ways to approve low-risk customers, and the Wall Street Journal reports that many large lenders are working with credit bureaus and other companies to access alternative data sets that can help paint a more complete picture of an applicant's risk profile. These include whether the applicant has received benefits such as unemployment, as well as cash flow history from the applicant's checking account.

Related reading: Waiting on a credit card application approval? Here's how I speed up the process

FICO is working to develop an index that will appear next to your credit score and tell banks how your finances are likely to be affected during an economic downturn, while Experian is creating a similar tool using metro-level economic data. For the near future, banks are also likely to favor applications from customers who have checking or investment accounts with them, as this gives them a more complete picture of your financial situation.

Related reading: The surprising reason I was rejected for a Chase Ink card

Bottom line

A rapid economic downturn like the one we experienced earlier this year demands a rapid response, and sometimes that leads to unintended consequences. While loan deferrals have helped many borrowers stay afloat during extended periods of unemployment, they've also made it harder for banks to tell how risky applicants are based on just their credit scores. Lenders are working to compensate for this through alternative datasets but, as is often the case during a recession, credit may not be easy to come by for some time.