Lending to small firms appears on the verge of transformation. Banks,
especially large ones, have increasingly adopted a new application of
technology called credit scoring to automate their small business lending.
Credit scoring is a statistically based means of underwritingevaluating
the expected repayment performance of a loanthat can substantially
decrease the time, human input and cost of reviewing applications. The
shift could have particularly important implications for small banks that
traditionally rely on small business lending.
One can best understand the larger implications of the new regime
through analogy with a firm that is neither a bank nor a small business,
Wal-Mart. Five years ago The Region reviewed how the
rise of discount stores such as Wal-Mart altered the Ninth District's
retailing landscape (see "Substance
Before Style," September 1992). These firms provide a wide range
of products at comparatively low prices while serving areas previously
believed beyond mass marketers. They succeeded by adopting new information
technologies, such as systems that identify and cheaply replenish
profitable merchandise, and leveraging their massive scale. Both
factors were critical in underpricing and outstocking other retailers.
Small business loans were also considered somewhat peripheral for
many large lenders just as rural markets were outside the sights
of large retailers. Large banks did not think they could apply automated
lending to small businesses. But research into the relationship
between the credit quality of owners and their small businesses
has convinced some banks to score small business loans. Ultimately,
credit scored small business loans could take on the general characteristics
of credit card loans with their high volume, convenient distribution
channels such as the mail and phone and high-tech assessment of
Wal-Mart's efficient and technology-based retailing to smaller
towns produced ambivalent feelings. Of course, mass discounters
cannot attain growth and profitability without meeting the needs
of consumers better than their rivals. Indeed, many small retailers
charging full retail prices had difficulty competing with the national
discounters and some towns lost many of their local merchants. Nonetheless,
proprietors losing business of customers they believed loyal cannot
avoid disappointment. More generally, the loss of local retailers
has led some residents to conclude that the intangibles of small
town life have been replaced by an inferior and sterile product.
Banks using credit scoring to increase their small business market
share are not explicitly targeting borrowers of community banks.
However, like Wal-Mart and small-town retailers, large banks recruiting
existing small business borrowers will inevitably run into smaller
banks. Banks with assets of less than $500 million held nearly 60
percent of all business loans under $100,000 even though they controlled
only 18 percent of banking assets as of June 1996. (Data on small
loans provides insight into small business borrowing because loan
and borrower size are highly correlated.)
Like the small retailer, the smaller banks can meet the competition
by differentiating themselves from larger banks that try to make
small business loans a commodity. What about questions of community
life? Will there be Wal-Mart like ambivalence? Do residents of small
towns care if preapproved solicitations and calls to toll-free numbers
replace face to face contact between borrowers and the local lender?
A closer look at small business lending and credit scoring should
inform the discussion of the broader questions the new technologies
Small business lending by banks in the Ninth District and United
Banks are extremely important providers of credit to small businesses.
A recent analysis by the Federal Reserve found that banks provided a little
over 60 percent of small business credit outstanding in 1993. But, is
small business lending important to banks? Graph 1 indicates that smaller
loans make up a significant minority of business loans (commercial and
industrial loans and business loans secured by nonfarm, nonresidential
property) made by banks nationwide.
Small loans make up a much greater portion of business lending by banks
in the Ninth District. And the smaller the bank the larger the role of
small business lending. Sixty-three percent of the business loans held
by banks with less than $100 million in assets (about 85 percent of Ninth
District banks at the time) were for under $100,000. In contrast, 62 percent
of loans held by banks with assets greater than $1 billion were for over
$1 million. Graph 2 provides additional detail on the distribution of
business loans by the size of the loan and the bank. Small banks in the
Ninth District, as with banks in the nation as a whole, hold a disproportionate
amount of small business loans. Banks with assets of less than $500 million
held 80 percent of all business loans under $100,000 despite controlling
only 47 percent of district assets. Graph 3 provides additional detail
on the business loan market share of banks according to the size of the
bank and the size of the loan.
Why does business lending by small banks exhibit a heavy concentration
of small business loans? Small businesses predominate in some locations,
leaving a small bank with little opportunity to make larger loans. In
addition, big loans could present too much of a risk for small banks.
Banks need to diversify their portfolio in order to reduce the chance
that the default of a single large borrower would expose the bank to catastrophic
Small banks have also traditionally been considered better positioned
to make loans to the local small business.
- The small bank may have better information on local
business and economic conditions, through informal meetings and
conversations with business owners for example, than larger banks
without the same presence in the community.
- The small bank could have information on borrowers
from activities in the savings and checking accounts that the
small business maintains with the local bank.
- Both the bank and the small business benefit by
continuing their relationship after an initial lending transaction.
Economists with the Federal Reserve Bank of New York note that
long-term borrowing arrangements, "... enable banks to collect
information about the borrower's ability to repay, reducing the
cost of providing credit. Borrowers, in turn, enjoy better access
to credit and lower borrowing costs. Small banks make more of
these 'relationship' loans than do large banks ..."
- Smaller banks can more flexibly apply their lending
criteria to small borrowers. It is harder for management at a
large bank with far flung operations to monitor the behavior of
loan officers. Large bank management may require that all loans
meet easily reported and observed financial tests as a result.
Loans approved by local staff that do not meet the financial ratios
wind up on special monitoring lists. This system may make local
staff loath to make loans that do not pass the hurdles established
by the central office. Management at a small bank can more easily
review and approve loans making it less necessary to implement
The advantage of small banks over large banks is, in a word, information.
Credit scoring for small business loans turns this dynamic on its
head. Proponents of quantitative scoring argue that it provides
information on the future performance of the small business borrower
such that they can profitably extend credit to a firm even if bank
employees have never met the firms' principals.
Credit scoring small business loans
Credit scoring systems assign a single quantitative measure, or
score, to a potential borrower representing an estimate of the borrower's
future loan performance. Scores correlate with odds of the loan
yielding "good" or "bad" performance. The definition of good and
bad depends on the particular scoring system but, in general, a
good loan meets banks' profit standards while a bad loan would not.
Analysts developing scoring systems identify those characteristics
of borrowers that best predict loan repayment. The developer then
statistically assigns each of the characteristics a numerical weight
so that the credit system measures the relative importance of a
given characteristic in accurately forecasting repayment.
The outcome of these statistical procedures is a "score card" on
which the characteristics of the borrower are noted and the score
tallied. Analysts can derive scores from consumer credit bureau
data such as a borrower's current level of indebtedness or previous
repayment performance. Some scoring systems use credit bureau information
supplemented with specific variables obtained from the loan application
such as the size of the loan relative to the value of the object
Credit scoring systems, however, are not like HAL, the all controlling
computer from 2001: A Space Odyssey. Most importantly,
the systems do not independently approve or reject a loan application.
The lender must decide how he or she will incorporate the credit
score into the loan review. The lender may decide to approve all
applications above a certain score, reject all loans below a lower
score and have a human underwriter review all loans that fall in
between the cutoff points. Many lenders have significant experience
in using credit scoring and making cutoff decisions become consumer
loans such as credit card and auto loans have been underwritten
with credit scores for decades.
Years of credit scoring would not seem at first blush to offer
much help in evaluating the credit quality of a business loan. Human
review and personal contact have long characterized business loan
reviews. Yet, in many cases the financial wherewithal and decision
making of the small business extend from the owner of the firm.
Therefore, the willingness and ability of the business owner to
repay personal borrowings could reasonably be assumed to correlate
with the ability and willingness of the firm controlled and managed
by the owner to repay its loans. Developers of scoring systems,
most notably Fair, Isaac and Co. Inc. (FICO), argue that their empirical
analysis of a large database of small business loans support this
observation. They found that the same variables determining the
owner's probability of loan repayment also determines a large part
of the credit score for the small firm.
FICO asserts that augmenting data on the owner of the firm with
very basic information obtained from a loan application and a business
credit bureau, such as past credit repayment experience collected
by Dun & Bradstreet, produces a reliable credit score. Perhaps more
importantly, FICO claims that data which had heretofore received
much scrutiny in the traditional underwriting process, such as ratios
from financial statements, are not crucial in determining the repayment
prospects of the small firm. In fact, FICO's most popular small
business scoring system does not require the small firm to provide
How could this seemingly technical change in loan review fundamentally
alter the mechanics of small business lending?
- Lenders can extend credit to small businesses without
any face to face contact by relying on third-party data. This
makes lending to businesses in locations where a bank has no physical
presence possible through means such as mailings of pre-approved
applications. A Consumer Banker Association survey found that
a quarter of respondents had mailed pre-approved small business
applications in 1996 while almost no respondents had done so in
1992. Renewals, adjustments and administration of loans or lines
of credit can take place over the phone.
- The documentation required of small business borrowers
is greatly reduced. Applications for credit scored small business
loans are often a single page.
- Credit scoring leads to much faster review. Lenders
can underwrite a small business loan in minutes and close it within
hours instead of days.
- A credit scoring based system could allow lenders
to reduce their costs. Lenders could replace human underwriters
with a combination of software and lower-paid data entry personnel.
More generally, lenders often incorporate credit scoring in the
reengineering and automating of lending. The retooling could cut
costs, in part, by decreasing the amount of documentation produced,
keyed into the system and reviewed. Banks capable of funding a
large loan portfolio could also spread the fixed costs of computer
or support systems for borrowers over a larger number of loans
thereby reducing per loan costs. Wells Fargo, a leader in this
field, made over 200,000 loans for $4 billion through its pre-approved
small business program as of June 1996. They hope to make over
$25 billion in such loans. A small bank could not benefit from
anywhere near this level of activity.
- Banks could reduce loan losses if credit scoring
provides a more accurate assessment of risk. Underwriters may
also concentrate their reviews on the loans that require the most
human attention under a credit scoring regime. Finally, scoring
allows lenders to apply and change their standards in a more consistent
- A more quantitative assessment of risk may allow
for loan pricing that better reflects the risk of the loan. Wells
Fargo charges small firms loan rates ranging from the prime rate
plus one percentage point to the prime rate plus eight percentage
points (the prime rate as of the end of September was 8.5 percent).
Banks using judgmental human reviews are not normally believed
to differentiate pricing to this degree. Risk-based pricing may
offer relief for high-quality borrowers who had previously been
subject to fairly flat rates. While some credit scored loans may
have very high interest rates, the borrowers who receive them
may not have qualified for any credit under traditional underwriting.
- Automated underwriting and origination systems made possible
by credit scoring may allow lenders to increase lending volume.
Technology moves small business loan production toward mass and
away from hand production. And credit scoring could make risk-based
pricing a viable alternative to the rationing of credit.
These changes could dramatically modify the look and feel of small business
loans. Borrowers could obtain and manage their small business loan like
a run-of-the-mill credit card instead of filling out applications with
details on financial performance and operating plans. With the changes
in the small business loan may also come a transformation in the competitive
environment to make these loans.
Competition for small business loans under the new technology
A long-run concern for banks has been the rise of alternatives to
their mainstay products. Some large companies, for example, can
obtain lower-cost financing by directly accessing securities markets
instead of banks. Banks have sought out new markets to replace those
they can no longer efficiently serve in order to maintain growth.
The small business loan market offers large banks the opportunity
to increase market penetration because of their relatively low existing
Lenders using the automated credit scoring approach could bring
lower costs, a new ability to target and assess small business borrowers
outside their areas of current operation, and an increased ability
to make a large volume of small business loans in a short period
of time. As one official from a large Pittsburgh bank that uses
credit scoring noted, "If we are going to grow at the rate we want
to, we have to go outside our geographic market. When we go to Kansas,
we will have the lowest costs and go after the highest credit quality."
This large bank will not enter the heartland alone. The use of
small business credit scoring has grown quickly, especially among
large institutions. A survey of senior lending officers of larger
banks by the Federal Reserve in early 1997 found that a little over
70 percent of respondents used a scoring system when making small
business loans, with banks over $15 billion in assets most likely
to use scoring. FICO reports that the vast majority of the leading
small business lending banks use a credit scoring system. In the
Ninth District, First Bank has moved to widespread scoring of their
smaller business loans. Of course, nonbank lenders can also avail
themselves of credit scoring. Nonbank firms like American Express,
AT&T and the Money Store have targeted small business borrowers
and could use the new technology in their efforts.
The entry of low-cost lenders into markets where small banks hold
significant share should increase competition. A greater number
of lenders competing for the current borrowers of small banks could
lead small lenders to earn less than they would have otherwise on
the small business loans they make. In particular, the lower cost
providers could undercut the smaller lenders on credit extensions
to the higher quality borrowers. By analogy, Wal-Mart could provide
standard, brand name products at better prices than the local competition.
The credit scoring approach could also increase the number of competitors
for small business borrowers by making it more feasible to sell
groups of small business loans to investors. Investors have been
reluctant to buy pools of small business loans because the variety
of loan structures, underwriting and documentation makes it difficult
to judge the pool's expected cash flows. Lenders may try to eliminate
these differences in order to take advantage of the efficiencies
offered by an automated underwriting and origination system. Investors
ranging from pensions to individuals should willingly fund small
business loans if they can buy interests in pools of homogenous
small business loans with predictable cash flows. Small banks would
then have to compete with international capital markets for small
business lending.See discussion
on some additional developments in the packaging and sale, or
securitization, of small business loans.
Of course, no one can guarantee the success of small business
credit scoring even if many banks move to these systems. Initial
response rates to preapproved loan mailings have been quite low.
It will take time before large banks make the most effective use
of the new technology. In the interim, large banks face the often
difficult and costly task of moving from an existing to a new lending
process. And, new technologies always face the chance that they
will perform much less satisfactorily than expected. The scoring
systems may not predict loan outcomes as reliably as hoped, and
banks may draw incorrect inferences from the information the systems
Yet, there are some signs that big banks have gained advantage
through credit scoring, although it remains far too early to declare
it a long-term success. The amount of very small business loans
(under $100,000) made by banks with assets over $5 billion increased
by 16 percent from June 1995 to June 1996. These smaller loans are
the most similar to personal loans of the business owner and are
thus believed amenable to credit scoring. At the same time, other
small business lending did not increase and loans for over $1 million
increased by a little less than 3.5 percent. In contrast, large
banks saw a huge increase in loans over $1 million and only a 4
percent increase in loans for under $100,000 from June 1994 to June
1995 when credit scoring was much less common.
The Federal Reserve banks in Kansas City and San Francisco recently
reported similar trends in business lending by large banks in their
regions and attribute them to credit scoring. Some analysts believe
that market structure of small business lenders in the future will
resemble the current credit card market because of the growing similarities
in the production of the two types of loans. This transition would
involve significant consolidation of small business lending as the
top 10 credit card lenders control more than half of the market.
New competition and society's interest
The specter of increased competition has not been the normal concern
raised in conjunction with large banks and small business lending.
Policy-makers and bank advocates traditionally worry that large
banks would take over smaller banks and curtail the amount of small
business credit they made available locally (recent empirical research
suggests that this fear is overblown). Should there be any concern
about the movement away from the current norms of small business
lending even when the amount of credit available to firms could
The fate of the incumbent small banks, like that of smaller retailers
facing Wal-Mart, depends on the behavior of local consumers and
of the banks themselves. Local banks could ignore the potential
threat and rely on the loyalty of existing customers. Such a strategy
offers real risk in price-conscious times. Small banks could also
try to retain market share by increasing their cost-cutting and
lending efforts. These banks could facilitate cost cutting and growth
through scoring systems offered by third-party vendors. However,
the relatively limited number of businesses that community banks
can serve and their inability to match the cost efficiencies, investment
capabilities and supporting products offered by larger banks could
limit the success of this option.
Small banks may have better luck by emphasizing and improving their
traditional strengths of personal service and flexibility with borrowers.
Communicating with their lender via mail and phone will not meet
the needs of some borrowers. These borrowers will pay more for personal
contact and advice offered by the small local bank. Moreover, some
borrowers will want terms and conditions outside the standard contract
offered by the large banks. In addition, lenders may not feel comfortable
credit scoring the applications of certain firms on which reliable
repayment data is not available. Smaller banks could compete for
these non-conforming borrowers. The number of small business borrowers
not eligible or not interested in the credit scored products will
determine the success of these strategies.
No one knows the fate of the small business lender facing the new
competition. But, we do know that full competition in lending makes
it more likely that small firms can regularly access credit in the
most effective manner. Surely the growth of one set of service providers
at the expense of another can severely hurt specific lenders and
individuals. Ultimately, however, ensuring that consumers are best
served by efficient credit markets is more important than retaining
a particular institutional form to lend to small firms, whether
it be banks, finance companies or a completely new type of lender.
Where do communities fit into this consumer-oriented framework? One intangible
of community commercial life has been the relationship between the local
banker and the local small business. The new lending paradigm would cut
that cord. Furthermore, it is possible that while individual firms consider
their own costs and benefits when reviewing a loan offer, they do not
account for the costs created when the larger community life that they
favor is negatively impacted by their borrowing decision. As a practical
matter, communities cannot prevent local firms from accessing outside-of-the-community
sources of credit. Small towns cannot zone an offer from American Express
to a small firm out of bounds as some were able to restrict the development
of Wal-Mart stores. Those that believe the community impact should, but
does not, affect decisions made by individual firms are left with the
task of providing information such that these alleged costs are considered
when small firms look for financing.