Credit Scoring: a Tool for Small-Business Lending

Credit scoring is providing an opportunity for banks and other lenders to more efficiently evaluate loan risks and lower the costs of small-business lending. Many banks, both large and small, already have begun to probe the possibilities of credit scoring techniques for small-business markets.

Historically, credit scoring has been limited to the underwriting of consumer loans and home mortgages. In contrast, lenders believed that they had to assess the ability of the small business to generate revenue to determine its repayment prospects. More recently, analysts determined that a bureau score of an owner of a small business is highly predictive of the loan repayment prospects of the business. The bureau score of the business principal can be augmented with very basic information on the nature of the business and data from a business credit bureau, such as Dun & Bradstreet, to produce a type of credit scoring system for small businesses.

Once developed, credit scoring, coupled with loan standardization, may offer significant cost advantages for evaluating the risks associated with lending. As these two systems become more commonplace, the ability of banks to "securitize" small-business loans likely will be greatly enhanced. A key benefit of securitization is that it potentially increases the liquidity of small-business lending and provides banks and other lenders with additional sources of funding. One would expect the cost savings generated through lower origination costs, better risk assessment and greater liquidity to be passed on, at least in part, to small-business customers.

Credit scoring may alter small-business lending in three areas: the interaction between borrowers and lenders, the pricing of loans and the availability of credit.

Borrower-Lender Interaction: Traditionally, a small-business owner wanting a loan had to meet with a loan officer in person and submit an application, including financial statements, business plans and a variety of other records. It could take days for the loan officer to review the documents. And not just data were examined during the loan review; the "character" of the borrower could play a significant role in the decision. Credit scoring eliminates the need for this level of interaction. In fact, by using a credit-scoring system, a lender with no physical presence in a community can lend money to small businesses without ever seeing a business plan or financial statements.

Loan Pricing: The price of small-business loans will decline for higher-credit quality borrowers under credit scoring because these borrowers no longer have to bear the cost of a full human underwriting. Moreover, these high-quality borrowers will have access to a greater number of lenders. Lenders from across the country will be able to reach out to the small business via direct marketing. This increase in competition also should reduce the costs of funds to small businesses. Finally, some businesses that previously had been thought to be high risk under a traditional underwriting system may be classified as lower risk under a credit scoring system.

Not all borrowers, however, will see their loan costs decrease because of credit scoring. A borrower whose credit score indicates that a full-scale human review is required may actually face higher costs. Previously, the fixed costs of human underwriting were spread among all the applicants. Under credit scoring, a significant percent of the loans will receive a limited human review, thus forcing those reduced number of loans that still require a full-scale review to bear the bulk of the fixed costs of traditional underwriting. Furthermore, credit scoring makes pricing according to risk much more feasible. The small-business borrowers who were being undercharged through the traditional underwriting system relative to their risk of default or delinquency now will face higher costs for credit.

Availability of Credit for Small Business: Better information about the repayment prospects of a small-business applicant makes it more likely that a lender will price the loan according to its expected risk. This prospect should increase the availability of credit to small businesses.

More important is the indirect ability of credit scoring to increase the size of the pool of funds small businesses can tap. Currently, there is a very small market for securitized small-business loans, for two reasons. First, there is not much data on how these loans perform over time. And second, small-business loans—even those made by the same bank—may vary in their underwriting, payment terms and loan structure. Both these factors make it very difficult for an investor who wants to buy a security backed by a pool of these loans to determine the cash flows that such a pool will produce. Investors are unlikely to buy securities backed by an uncertain cash flow and may ask the lender, for example, to sell the loans for less than what the lender thinks they are worth. Credit scoring small-business loans addresses both of these problems.

The highly computerized scoring systems make it easy to collect data on the performance of loans over time. To use a credit scoring system cost-effectively, a lender must also make its small-business loans fairly homogenous. Otherwise, the system will not be able to process many loans in a short period. Using a scoring system to rate heterogeneous loans would be like using the same machine to process many different shaped and sized widgets. In total, the credit scored small-business loans should be much easier to securitize. A vast pool of funds opens up to small businesses once lenders can securitize small-business loans. Indeed, investors throughout the world who currently invest in asset-backed securities would be able to invest in small-business loans.

Clearly not all small business loans are going to be appropriate candidates for securitization, and not all banks will wish to adopt complex statistical models for managing risks. There will continue to be a market for nonstandard small-business lending and a role for regional and community banks.

Much of this article was excerpted with permission from "Credit Scoring and Small Business Loans," by Ron Feldman, Community Dividend, Spring 1997, Federal Reserve Bank of Minneapolis.