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San Francisco Regional Outlook - Second Quarter 1997

In Focus This Quarter Will Credit Scoring Transform the Market for Small-Business Lending? Small-business lending, traditionally a segment in which small banks have enjoyed comparative advantages, is receiving greater focus from larger banks and nonbank financial companies. Some insured institutions are beginning to rethink traditional approaches to small-business loan underwriting to include the use of credit scoring models. The use of small-business lending credit scoring models, while providing banks opportunities for underwriting and servicing efficiencies, carries with it a number of potential risks. Background As of 1994, there were more than 22 million small businesses in the U.S., making this a very attractive potential market for lenders.  Small-business lending has been a line of business in which small banks have been very successful given their traditional strong niche in relationship banking.  Small-business lending traditionally has been a relatively cost-intensive lending segment, since origination costs are spread over smaller loan balances.  Some institutions are now beginning to use credit scoring technology to reduce underwriting costs and to grow their small-business lending portfolios.  A number of larger banks, especially, appear to be looking to the efficiencies of credit scoring to help provide quick loan approvals and more competitive loan rates.  With the aid of this technology, some institutions are rapidly expanding their loan portfolios, in some cases venturing into markets well beyond their local economies. Commercial bank small-business lending exposures in the San Francisco Region are considerable. (For purposes of this article, small business lending refers to loans categorized as commercial and industrial loans with original amounts of $1 million or less reported on the June Call Reports.)  At midyear 1996, commercial banks in this Region reported $25 billion of small business loans, amounting to 25 percent of all commercial and industrial loans.  This is an increase of $1.4 billion or 6 percent from one year ago.  There are 382 banks in the Region with small-business loan exposures exceeding equity 100 percent of equity and 103 banks with exposure exceeding 200 percent of equity. Small banks, those with assets under $1 billion, have a substantial share of the Regions' small-business loans, holding 39 percent.  However, large banks over $10 billion are increasing their presence in the small-business lending market.  These large banks seem to be concentrating their efforts on smaller-size loans (under $100 thousand), which grew 35 percent in the last year (See Chart 1). In California, the trend is even more pronounced, as some of the state's largest banking companies have announced nationwide programs to increase their market share of small business lending.  These nationwide programs may have been prompted by the new credit scoring technology.  Several of these companies reportedly are offering pre-approved and pre-qualified lines of credit through the use of credit scoring technology. Chart 1 Source: Bank Call Reports The Growing Importance of Credit Scoring While credit scoring technology is not new, until recently it typically has been associated with consumer lending, particularly with credit card lending.  Primarily using credit bureau information, credit scoring provides lenders with a tool to rank risks or probabilities of default, assigning statistically derived numerical ratings or scores based upon a borrower's past experience with paying debt.  Based upon the enormous volume of historical information on consumers contained in credit bureaus, model developers link incidences of good and bad credit performance with borrower characteristics.  Applicants then are compared to these credit performance indicators in order to make credit extension decisions.  While credit scoring has helped consumer lenders reduce origination costs and to grow receivables at rapid rates, the recent rise in credit card charge-offs has raised concerns about the effectiveness of such models, or at least about how the scoring models are being used. Small-business credit scoring is a relatively new concept in scoring technology, but is gaining more attention from lenders.  Small-business credit scoring models are similar to consumer credit scoring models in one significant aspect -- the most important indicator of credit performance is the credit profile of the principals of the business derived from consumer credit bureau information.  Other business information from companies such as Dun and Bradstreet Corporation and Experian (formerly TRW) also is used in the scoring process. A primary vendor of these scoring models has cited analysis purporting to show that business financial statement information did not prove a useful indicator of credit performance for small-business loans.  The reasons for this result may be due to inconsistency in financial statement quality and the difficulty in separating business entity cashflow information from the business owners' activities.  Also, the relative importance of principals' credit history and financial statement information in predicting credit performance was found to change somewhat with the size of the business -- the larger the business the more important financial statements become in assessing performance. Many institutions cite the potential cost savings involved in the underwriting process as one of the most significant characteristics of credit scoring.  In many cases, with scoring technology, loan application processes have been streamlined to one page forms for loans up to $50,000, not dissimilar to that of consumer loan applications.  In some cases, financial statements are not required at all.  Reducing paperwork helps to reduce both processing time and costs.  Table 1 illustrates how scoring has changed underwriting practices, as reported by one large bank at a recent conference on credit scoring.  While it is impossible to know whether the information presented in Table 1 is representative of the way most institutions are using credit scoring models, it is clear that credit scoring may represent a significant departure from traditional underwriting methods. Table 1 Source: Reported by a Large Bank at a Recent Conference on Credit Scoring. Part of the reduction in underwriting costs may come from improvements in the allocation of underwriting resources.  It has been argued that credit scoring allows banks to more easily identify those applicants which are clearly either approvals or denials.  This process would enable banks to reallocate their underwriting resources more efficiently to those loans which pose intermediate risks and require closer attention.  Other advantages of credit scoring systems that often are cited are greater consistency in underwriting, better measures for pricing strategies, and the potential to enhance the ability to securitize small-business loans. What Are the Risks? Small-business lending has historically been a profitable area of bank lending. This situation is most likely attributable to lenders thoroughly analyzing potential customers, persistently monitoring their performance, and building solid lending relationships.  Credit scoring for small-business lending raises the possibility that some banks will forgo the traditional underwriting concepts of relationship lending in favor of a more mass-marketing approach, in a manner similar to credit card lending.  To the extent that credit scoring is used to rapidly gain new customers by either targeting out-of-territory customers, or customers with less business experience, the risk profile of an institution's small-business lending portfolio may change.  Any such change in profile may be significant due to the risks associated with newer borrowers.  For example, new firms tend to fail at an extremely high rate, with 53 percent of new businesses failing within the first four years of inception (See Chart 2).  Larger, more established commercial businesses tend not to exhibit such volatile characteristics.  There are potential dangers associated with placing undue reliance on credit scoring models. The predictive value of any credit scoring system may be substantially diminished if the model is used for unintended purposes or customer types.  Therefore, misuse of a scoring system could expose an institution to considerable losses.  Since only the largest banks have small-business loan portfolios large enough to create statistically valid scoring models customized for their own customer base, smaller companies should be especially aware of potential misuse.  This risk takes on added meaning when one considers that a $1 million small-business loan represents substantially more capital to a $100 million bank than to a $10 billion bank.  Adding further uncertainty, small-business credit scoring has been implemented during a period of relatively strong performance by businesses, with commercial and industrial loan delinquency ratios near historical lows.  How well these models perform during an economic downturn remains to be seen. Chart 2 Source: Small Business Administration Depending on the manner in which it is implemented, credit scoring for small-business lending may represent a fundamental shift in underwriting philosophy -- viewing a small-business loan as more of a high-end consumer loan and, thus, granting credit more on the strength of the principals' personal credit history and less on the financial strength of the business itself.  While this may be appropriate in some cases, it is important to remember that the income from small businesses remains the primary source of repayment of most loans.  Banks that do not analyze business financial statements or periodically review their lines of credit may lose an opportunity for early detection of credit problems. Competitive pressures in small-business lending are increasing not only because of large banks' efforts to expand their lending but also because of greater participation in the market by nonbank financial companies.  Several large firms, such as American Express, AT&T, the Money Store, and GE Capital Services, are expanding their business lines to service the needs of small businesses.  These companies are offering small-business credit cards, innovative new types of credit, and other services such as consulting, accounting and investment services.  Some observers have suggested that the cost advantages of credit scoring may cause small-business lending in the future to be dominated by 12 to 15 large banks or financial firms.  Faced with stiff competition, there may be strong motivation for some banks to increase the dollar threshold on low documentation loans, streamline the process for larger loans, or lower credit scoring thresholds for loan approvals.  The most recent FDIC Survey of Underwriting Practices and the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices both indicate that only a small percentage of banks reported an easing of standards on small-business loans.  Aggressive competitive pressures and loan growth goals were seen as the main reasons for easing in these cases.  With regard to small-business credit scoring techniques, the Federal Reserve survey pointed out that banks were most commonly using credit scores for automatic acceptance or rejection of loans up to $50,000. Summary Credit scoring has the potential to transform the market for small-business lending.  The traditional niche enjoyed by small banks in this area may come under tremendous pressure from larger banks and nonbank companies employing this new technology.  Credit scoring at a number of institutions is driving dramatic changes in underwriting methods for small-business lending.  These changes may facilitate short-term revenue generation as business can be expanded rapidly and underwriting costs can be slashed.  It is extremely important, however, that banks understand and control the potential risks inherent in such a strategy.  The application of credit scoring to small-business lending merits the close attention of both bankers and their supervisors. Andrea W. Bazemore, Banking Analyst Regional Outlook main page