Magazine article Business Credit

Small Business Credit Scoring

Magazine article Business Credit

Small Business Credit Scoring

Article excerpt

Lending to small business has traditionally been a very time-consuming and costly proposition for banks and other financial intermediaries. The main reason for this is the extent of asymmetric information in the small business credit market, reducing competition in the small business tending market so firms which are good credit risks often pay handsomely for access to credit, even when the bank or firm lending to them has established their creditworthiness.

Over the past 15 years, this situation has gradually improved in many developed country markets as small business credit scoring (SBCS) technologies have been adopted by banks and other lenders. Credit scoring is based on real data and statistics, so it usually is more reliable than subjective or judgmental methods, as it treats all applicants objectively. Judgmental methods typically rely on criteria that are not systematically tested and can vary when applied by different individuals. SBCS tools enable lenders to rapidly evaluate the risks associated with different borrowers according to objective and statistically validated criteria. As a result, risks can be better managed, borrowers can be more confident that loan decisions are based on their qualifications and the credit granting process has been streamlined with processing times fatting from days and weeks to a matter of minutes in some cases.

In most developing country markets, however, SBCS technologies still have only limited use. This is likely due to a variety of factors including poor lending practices, small market sizes and incentives for maintaining relatively labor-intensive loan processing technologies rather than automating. On the other hand, in some developed markets, such as the U.S., Canada and Japan, lenders have joined together and shared data on their small business lending portfolios in order to develop a pooled data credit scoring tool.

How Is A Credit Scoring Model Developed?

To develop a model, a creditor selects a random sample of its customers, or a sample of similar customers if their sample is not large enough, and analyzes it statistically to identify characteristics that relate to creditworthiness. Each of these factors is then assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its own credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company.

Credit scoring models are complex and often vary among creditors and different types of credit. If one factor changes, your score may change--but improvement generally depends on how that factor relates to other factors considered by the model. Only the creditor can explain what might improve your score under the particular model used to evaluate your application.

Nevertheless, scoring models generally evaluate the following types of information in your credit report:

* Have you paid your bills on time? Payment history is typically a significant factor. It is likely that your score will be affected negatively if you have paid bills late, had an account referred to collections, or declared bankruptcy.

* What is your outstanding debt? Many scoring models evaluate the amount of debt you have compared to your credit limits. …

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