Personal contact between small business owners and
their banks is at the heart of community commerce in towns and rural
areas throughout the Ninth Federal Reserve District. The connection
between community banks and small business is not merely the result
of the "everyone-knows-everyone" environment that often characterizes
nonmetropolitan life. Many bankers will not extend credit unless
they have in-depth knowledge of the plans and operations of the
prospective small business borrower. However, what if knowledge
of local conditions and face-to-face contact with the borrower is
unnecessary for making sound loans? Indeed, what if gathering such
information actually hurts the competitive position of the community
bank? The recent but growing ability of lenders to underwrite small
business loans via a highly automated and cost-effective process
known as credit scoring moves such questions from the hypothetical
to the practical.
The move to credit scoring could have broad implications for small
banks, small businesses and small towns despite the seemingly technical
or arcane nature of this change. Credit scoring should greatly reduce
the time and paper needed to apply forand monitora small
business loan. These systems should also decrease the costs of borrowing
for small businesses with higher credit quality, and conversely,
increase the costs for borrowers with lower credit quality, while
increasing the total amount of funds available for small business
lending. In addition, credit scoring should put downward pressure
on the profits that community banks currently earn on small business
loans, although it may open up new areas of profitable business.
Finally, credit scoring could alter the environment in which community
commerce takes place. Small business lending is often characterized
by intense, personal contact between the lender and borrower. Credit
scoring makes it much more likely that this relationship will become
like the impersonal tie between consumers and their credit card
This article provides an in-depth look at credit scoring, detailing
what it is, how it is used to evaluate potential small business
loans, the implications of credit scoring for small business borrowers
as well as the implications of credit scoring small business borrowers
for community banks.
What is credit scoring?
Credit scoring is the process of assigning a single quantitative
measure, or score, to a potential borrower that reflects the borrower's
relative chance of going into delinquency or default.
These scores have been used for decades in the underwriting of
consumer loans, such as credit card and auto loans.
There are two main types of credit scores: the bureau or credit
history score and the application score.
The bureau or credit history score is based solely on information
available from a credit bureau. In developing the bureau scoring
system, analysts identify those characteristics of borrowers that
best predict whether they will repay their loans fully and on time.
The developer then statistically assigns each of the characteristics
a numerical weight so that the credit system correctly measures
the relative importance of a given characteristic in accurately
forecasting repayment. For example, the characteristic "never having
been delinquent" will receive a large weight if it is an important
predictor of not being delinquent in the future. The outcome of
these statistical procedures is a "score card" on which the characteristics
of the borrower are noted and the score tallied. Fair, Isaac and
Co., San Rafael, Calif., in conjunction with each of the three major
credit bureaus, is a leading provider of bureau scores. Their bureau
scores range from about 300 to about 900. The higher the score,
the more likely the loan will perform according to the expectations
of the lender.
The second type of score, the application score, incorporates
information on the loan and borrower beyond that collected by a
credit bureau. A mortgage score, for example, could be influenced
by the amount of the loan relative to the value of the property
Credit-scoring systems do not approve or reject a loan application.
Rather, the underwriter must decide how he or she will incorporate
the credit score into the loan review. Freddie Mac, one of the two
enormous government-sponsored purchasers of mortgages in the United
States, has suggested that lenders subject mortgage applicants to
three levels of scrutiny based on the bureau score of the applicant.
Freddie Mac suggests that those applicants with a Fair, Isaac score
of more than 660 should receive a limited review by human underwriters,
those with scores between 660 and 620 should receive a full-scale
human underwriting while those with scores under 620 should be approved
only with great caution. Ultimately, each lender must set its own
cut-off scores based on its risk preferences.
The recent but growing ability of lenders to underwrite small
business loans via credit scoring moves a string of important questions
on loan administration from the hypothetical to the practical.
The popularity of credit-scoring systems results from the advantages
that they offer the borrower and lender. Credit scoring has allowed
consumer lenders to:
- reduce greatly the cost of underwriting loans for borrowers
whose score indicates that a full-scale human underwriting is
unnecessary because they will almost surely be accepted or rejected.
- increase the speed at which they can provide a loan decision
and the number of loans that a lender can underwrite.
- underwrite and monitor loans without meeting the borrower. By
using bureau scores, a lender can directly market its loans to
potential borrowers who have a score above a certain cutoff. Credit
scoring thus makes preapproved credit card solicitation possible.
This manipulation of information allows lenders to tailor their
products to a target audience. Lenders can also use scores to
monitor the credit quality of their borrowers after they have
- predict their expected losses better. Credit-scoring systems
apply underwriting standards consistently and provide lenders
with estimates of future loan performance for borrowers of a given
score. Credit scoring should allow lenders to adjust interest
rates so they are compensated for the risks they incur. In contrast,
a lender may decide not to make a loan at all if it is unsure
of the expected loss associated with it. Credit scoring thus makes
risk-based pricing a viable alternative to credit rationing.
Credit scoring small business loans
Credit scoring historically had been limited to the underwriting
of consumer loans. In contrast, lenders believed that they had to
assess the ability of the small business to generate revenue to
determine its repayment prospects. Such a comprehensive business
review is not amenable to credit-scoring systems. More recently,
analysts determined that the bureau score of the owner of the small
business is highly predictive of the loan repayment prospects of
the business. The credit score of the business principal can be
augmented with very basic information on the nature of the business
(e.g., is it an entertainment provider or a manufacturer?) and data
from a business credit bureau, such as Dun & Bradstreet, to produce
one type of credit-scoring system for small business loans.
The most prominent small business loan scoring system was developed
by Fair, Isaac and the Robert Morris Association (RMA). It provides
lenders with a number of scorecards whereby they can choose the
system most appropriate for the characteristics of the loans they
are offering. For example, scorecards have been designed for different
sized loans and for businesses that do not provide lenders with
financial statements. Fair, Isaac reports that 250 banks use its
small business scoring system, while 25 of the top 30 banks with
the most outstanding small business loans credit score their own
small business loans. Several extremely large banks, including Wells
Fargo, Citibank, and Bank of America, also have developed their
own scoring systems. Wells Fargo alone issued $1.4 billion of preapproved
lines of credit to small businesses in 1995.
Implications of credit scoring for small business borrowers
Credit scoring will alter small business lending in three areas:
the interaction between borrowers and lenders, the pricing of loans
and the availability of credit. More generally, all of the characteristics
that credit scoring has brought to consumer loans will now be available
for small business loans.
Traditionally, a small business owner wanting a loan had to meet
with a loan officer of a local bank in person and submit an application,
including financial statements, business plans and a variety of
other records. It could take many 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. After the loan was made, the bank required that the
small business owner regularly submit updated financial statements.
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 via a
direct solicitation without ever seeing a business plan or financial
statements. Once approved, the borrowers may not have to provide
their lenders with updated financial statements. If a small business
owner comes to the branch of a bank that credit scores its loans,
his or her application can be approved very quickly. The credit-scored
small business loan would have much more in common with the credit
card loan obtained by the business owner in terms of borrower-lender
interaction than the traditionally underwritten small business loan.
The price of small business loans will decline for higher-credit-quality
borrowers under a credit-scoring regime because these borrowers
no longer have to bear the cost of a full human underwriting. Moreover,
these high-quality borrowers will now 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 should also reduce the costs of funds to small businesses.
Finally, some businesses that had previously been thought to be
high risk under a traditional underwriting system may be classified
as lower risk under a credit-scoring system. This reclassification
would encourage lenders to reduce costs for such small business
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 percentage
of the loans will receive a limited human review, thus forcing those
reduced numbers of loans that still require a full-scale human review
to bear the bulk of the fixed costs of traditional underwriting.
Furthermore, and as noted above, credit scoring makes pricing according
to risk much more feasible. The small-business borrowers who were
being undercharged based on the traditional underwriting regime
relative to the risk of default or delinquency they posed will now
face higher costs for credit. Using its credit-scoring system, Wells
Fargo, for example, has recently been charging its higher-risk borrowers
the prime rate (about 8.5 percent as of the end of March 1997) plus
an additional 8.75 percentage points.
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 instead of denying the loan out of
fear of charging too little and losing money. 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,
it is very difficult for a lender that has made small business loans
to sell the loans to investors. In contrast, lenders routinely sell
their mortgages and, to a lesser extent, their credit card loans.
The difference between the two situations is that a large market
exists for securities backed by a group of mortgages, credit cards
or other consumer loans. In this market, the investor will buy a
security whose principal and interest payments are actually supported
by payments made on the underlying mortgages or credit card loans.
The issuer of these asset-backed securities will use the funds of
investors to make additional mortgage or credit card loans. The
process of converting a pool of loans into a security that investors
are willing to purchase is aptly called securitization.
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 loanseven those
made by the same bankmay 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 under conditions amenable to the firm that originated
the loans. The investors 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 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 differently
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.
Implications of credit scoring small business borrowers for community
Credit scoring should increase the competition for lending to small
businesses in several ways. Large banks are already applying direct
distribution techniques to lend to small businesses that previously
borrowed from local institutions. More generally, a firm capable
of raising funds and buying a scoring system can more easily enter
the small business lending market. Furthermore, lenders making use
of credit scoring can provide credit to high-quality borrowers at
a lower rate than can banks that rely on the traditional underwriting
technique. Finally, the securitization of small business loans would
greatly increase the number of potential investors in these loans.
All these factors should put competitive pressure on the prices
that community banks can charge small businesses. Ultimately, this
pressure may reduce the profits that many community banks earn on
small business loans.
However, some community banks should be able to exploit profitable
opportunities presented by credit scoring. For example, a bank could
focus its efforts on lending to those small business borrowers who
want the personal contact that the credit-scoring system does not
provide. In addition, some small business borrowers will not wantor
may not qualify forthe standard loan that everyone else is
getting. Community banks can try to cater to these nonconforming
borrowers who will likely have to pay more for their nonstandard
borrowings. Finally, a community bank can try to increase its lending
via a credit-scoring system to make up for the lower returns it
earns per loan. However, the relatively limited number of businesses
that community banks serve and their inability to match the cost
efficiencies and investment capabilities of larger banks going after
the same markets limits the opportunity presented by these possibilities.
Conclusion: Changes in community commerce?
Predicting the future of financial services is a low-success venture.
Given that caveat, it does seem more likely than not that credit
scoring will significantly change the borrowing opportunities for
small businesses. Moreover, credit scoring small business loans
seems to pose a distinct threat to the profitability of some community
banks. The greatest unknown, however, is how the changes wrought
by credit scoring will alter the nature of community commerce in
rural areas and small towns. Will community life be modified significantly
by the severing of the personal relationship between local lenders
and local small businesses? Will the benefits that accrue to some
borrowers who have greater access to cheaper funds offset the costs
to community life and local banks?
There are no obvious answers to such questions. In fact, it would
seem unlikely that a technical change like credit scoring could
produce serious changes to community commerce. Yet it is clear that
changes in technology can alter the processing of information and
the distribution of products and that such changes have already
affected commerce in rural areas and small towns. One need not look
further than the effect of the Wal-Mart chain of discount stores,
with its sophisticated distribution and information management systems,
on small communities. Credit scoring is probably best understood
as another of the technological advances that will provide benefitsand
coststo nonmetropolitan communities.
Ron Feldman is a senior financial specialist in the Special
Studies Unit of the Minneapolis Reserve Bank's Banking Supervision
Department. He studies trends affecting financial institutions and
analyzes banking and supervision policies.