I have a love-hate relationship with credit scoring for small business clients. Having started my career in banking, where we moved from traditional underwriting to credit scoring, I have seen both the good and bad of scoring models. Over the past 20 years there have been numerous shifts in how financial institutions attract and attain small businesses. One of the primary transformations is due to credit scoring.
Each financial institution (FI) defines “small business” differently. Smaller institutions using credit scoring generally score all applications below $250,000, while larger institutions will go as high as $2M.
I’ll address the negative aspects first. Unfortunately, many small business lenders are salespeople that know very little about commercial underwriting. Their primary focus and remuneration are based on how quickly they obtain small business applications, get them to centralized underwriting, and see if they meet the FI’s criteria. Basic credit scoring is the perfect match for this model. You throw it in and, if it meets the criteria, the loan is approved. If it does not, the request is denied.
I understand this model for larger institutions. Large FIs must process a plethora of applications daily, while limiting the allocation of resources. For them, time and cost are of the essence and, frankly, they are not inclined to waste either on smaller opportunities. Hence the need to move them through underwriting quickly and efficiently.
Credit scoring for small businesses is based on two things: the owner’s personal credit score and the business’s score. Everything on a business loan application becomes a number. This number takes into account the NAICS code, years in business, vendor payment history, cash flow, company leverage, and a multitude of other items. It must be noted that every financial institution will have a different scoring methodology. If the personal credit score and business score fall into the correct grid, the loan is automatically approved. Those on the bubble are reviewed by an underwriter to determine if the credit is acceptable. Applications below the minimum thresholds are automatically denied by the system.
Seemingly innocuous items can cause this approach to go awry. Examples:
- A business owner’s credit score may have dropped due to a disputed insurance claim, triggered by an incorrect medical code, that resulted in non-payment.
- A business credit card or vehicle may show in both the personal and business credit scores, lowering the business owner’s global cash flow.
- A NAICS code given by the accountant may be incorrect for the type of business, lowering the business score.
- There are errors on applications due to an incorrect understanding of the questions that erroneously bring down the business credit score.
If the lender or underwriter does not take the time to review and understand these different scenarios during underwriting, the customer may not receive the requested credit facility. To add insult to injury, the client may not even learn why they did not qualify. They are simply told they do not meet the credit criteria for the FI and are left wondering why. There are too many variables to score commercial and industrial (C&I) loans effectively, given the general lack of underwriting experience on the part of many small business lenders.
Here are some positives of business credit scoring:
- It’s fast underwriting where the model can give automatic approval, subject to due diligence.
- The scoring will help price the loan based on risk. The higher the score, the better the rate.
- Branch offices and retail can take applications, lowering the cost of implementation by using existing retail outlets.
- All loans are underwritten in a centralized location, maximizing efficiency.
- It removes bias from the equation. The system does not care about ethnicity, gender, political affiliation, standing in the community, etc. This is a good thing as lenders are required by law to treat every applicant and application with the same care.
Effective scoring ultimately comes down to two things:
- Meaningful training for small business lenders. Training once a year on a process that requires detailed understanding is not sufficient, particularly when retail personnel who rarely see small business loans take the loan. Small business lenders need to know the intricacies of both the requirements for underwriting and their clients’ needs.
- Modern decisioning technology that incorporates both the institution’s credit culture and understands the business borrower’s needs. The institution should be able to determine credit requirements based on the market, institutional goals, and client need. The approach can be a hybrid of both FICO and traditional underwriting accompanied, when necessary, by a human assist to resolve any issues.
Savvy human capital plus innovative tech is the winning combination for underwriting that sensibly saves time while funding small businesses.
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