As banks focus greater attention on small business, they are discovering that they may not be able to apply to these customers the traditional model of commercial lending in which each loan is handcrafted and individually monitored. The lowering cost of technology is forcing banks to rethink their lending practices for small business, and streamlining and cost control dominate banks' agendas. New techniques are needed for:
* Improving the quality of credit extended and reducing write-offs.
* Making more efficient use of staff time devoted to credit analysis.
* Increasing consistency, compliance, and control in the decision-making process.
This article discusses how to achieve these objectives by developing a thorough yet efficient process for analyzing the risk in lending to the owner-managed business. It explains quantitative and qualitative factors that are important in evaluating the creditworthiness of small business customers, and includes a case study demonstrating the adjustments necessary to analyze a small business and its owners' financial position.
Defining the Owner-Managed Business
Most small businesses are run by its principal owner or owners. Business types include sole proprietorships, corporations, and partnerships and cover a wide range of industries. These businesses depend on banks and suppliers for most of their financing needs. It is a common misperception that small business means morn-and-pop, unprofessional, or lacking in growth potential; instead, small businesses today are more likely to be highly skilled, professional, and growth-minded.
Many banks find it necessary to divide the small business market into two categories because the definition of small business is broad, and it may be difficult to develop a standard credit process for all small business customers. One group of small businesses may be defined as 10-100-1-million companies: 10 employees or less, credit needs of $100,000 or less, and annual revenues of up to $1 million. Most owner-managed businesses are in this group, with some sources suggesting that this segment makes up more than 75% of the total small business market. Historically, these businesses have been difficult for banks to service because of the businesses' lack of financial sophistication as well as the small size of individual transactions, which make it hard to justify the costs of lending. It is often easier for these business owners to access consumer credit products than to obtain commercial loans. And the use of credit cards and home-equity lines can supplant the need for other types of credit. In response to these challenges, credit-scoring has emerged to forego costly interviews and reduce paperwork in the decision-making process.
The second group of owner-managed businesses are those that have grown beyond the 10-100-1-million group. Their representation in the market may be smaller in number, but they cover a wider range of size and industry classifications. These larger small business customers usually are the major portion of the bank's commercial loan outstandings and consume the greatest amount of time and resources in the credit process. For these companies, the lender or credit analyst makes a judgment about credit risk based on an assessment of the financial information of the business as well as an understanding of qualitative factors such as the quality of management, competitive position, and overall industry risk. Unlike credit-scoring techniques, human judgment plays a critical role in the decision process.
At either end of these two groups of business borrowers, procedures for credit analysis are seemingly straightforward and well defined. However, for the owner-managed business that falls somewhere in the gray area that divides the two groups, many banks find it difficult to develop a cost-effective approach for credit analysis. The solution balances thoroughness with efficiency, and it demands a structured approach that focuses the analyst's judgment on the relevant variables. …