Alternate appraisal techniques
We need to appreciate that the credit process in case of micro and small entrepreneurs cannot be identical to that of large corporations, where the borrower is able to provide detailed information about business plans and the firms financial statements and the lender carefully reviews the data using analytics that are time-consuming and expensive.
In view of the relatively small size of the loan, banks do not find it worthwhile to conduct an elaborate appraisal of SME credit proposals both in terms of value and profit. Therefore, in order that the banks can quickly conduct the appraisal of SME loan proposals without expending too much resources, it would be imperative to ensure the efficiency of the appraisal process.
Financial institutions in the developed countries use different lending techniques to provide funding to small firms. The banks, in these countries, use a version of a computerised loan-evaluation system, referred to as credit scoring, to assess would-be borrowers. The credit scoring approach, using computer technology and mass production methods, was originally designed to handle consumer loans, but are now being used effectively for lending to small businesses by predicting their potential loan delinquency. Credit scoring offers a modern alternative for the traditional method of evaluating loans for small businesses.
To expedite the credit flow to the MSEs, RBI, as a proactive measure, issued guidelines in May 2009, advising banks to start using scoring models for making lending decisions in case of all advances up to
R2 crore. However, despite, our instructions having been issued nearly five years back, we find that the use of credit scoring model in the real sense has not really taken off in India. Our assessment is that perhaps the lack of conceptual clarity on the subject could be one reason for the banks reluctance in using the credit scoring model. In fact, very often credit scoring is misunderstood or confused with credit rating.
What is credit scoring
Credit scoring is a statistical technique that combines several financial characteristics to form a single score for assessing a borrowers credit worthiness. The score does not predict a companys ability to pay, but rather its willingness to pay in a timely fashion. The probabilities of delinquency, as estimated by the model, are based on the analysis of previous applicants with similar characteristics. Credit scorecards are tools used to predict the behaviour of new applicants based on the performance of previous applicants (US Comptroller of the Currency, 1998). Scorecards can also be used to predict the performance of existing accounts, based on the past experience of accounts with similar characteristics.
Credit scoring is a model applied by banks in their assessment and approval or decline of the loan requests by SMEs. As there is a strong link between the payment behaviour of the business owner and that of the business, SME credit scores usually include financial characteristics from both the business and the business owner. Credit scoring is based upon information like how the repayment of the previous loans has gone, what is the current income level of the enterprise, what are the outstanding debts, if any
It focuses on the credit history of the enterprise. As part of the process, the lenders see whether the enterprise/business owner has the reliability and honesty to repay the loan. It also examines how the enterprise has used credit before, its record for repayment of bills, including utility bills, how long the enterprise has been in existence, assets possessed by the enterprise and sustainability and viability of the activities that the unit is engaged in. Credit scoring model draws inputs from historical information on the performance of loans with similar characteristics.
Credit scores have been widely used for many years in consumer credit markets e.g., mortgages, credit cards, and auto loans. In the mid-1990s, Fair Isaac and Company introduced one of the first credit scoring models developed exclusively for SMEs, the Small Business Scoring Service (SBSS). Since then, many SME banks in the US, as well as in Canada, the U.K., and Japan, have implemented some type of credit scoring for SME borrowers.
Different from credit rating
Credit scoring and credit rating are two entirely distinct concepts and to be employed in distinctly different scenarios. Credit scoring is a statistical technique that combines several predetermined characteristics to form a single score to assess a borrowers credit worthiness. Any two identical applications will always receive the same score. Credit rating, on the other hand, is based more on the experience and judgment of the credit officer and uses financial indicators as the key. The objective of scoring is to replicate the manual analysis and approval of loans at a lower cost, with greater speed, while the use of credit rating is reliant on the manual analysis by credit officers to supplement the rating provided by the tool.
To put it simply, credit scoring uses a retail lending approach to credit screening/decision making and is recommended for smaller ticket-size loans, where adequate reliable financial data about the borrower is not available. Credit rating is a more appropriate tool for larger, mid-segment or corporate loans, which have relevant financial data/business plans that provide the basis for further credit analysis and information.
Benefits of credit scoring
When used appropriately, credit scoring can benefit multiple stakeholders, including lenders, borrowers, and the overall economy. For the lender, scoring leads to process automation, which facilitates process improvements, leading to many byproducts such as improved management information, control and consistency. It also increases the profitability of SME lending by reducing the time and cost required to approve loans and increasing revenues by expanding lending opportunities.
A study in the US estimated that the cost of evaluating micro loan applications in the US using credit scoring was reduced to around $100 compared to a range of $500-$1,800 prior to the introduction of credit scoring. The time saving involved meant that banks could focus more time on marginal applications, existing loans that are showing signs of distress and processing more loan applications.
The Bank of England has also acknowledged that there is some evidence of banks being more willing to lend on an unsecured basis when using credit scoring, which potentially improves the access to bank finance for very small and start-up SMEs.
For the borrower, the benefits from credit scoring include increased access to credit and, in some cases, lower borrowing costs. In its study of SME credit scorings impact on access to credit, the Federal Reserve Bank (FRB) of Atlanta found that, in general, the use of credit scoring increased the amount of credit banks extended to the SMEs. It found that banks using scoring were more likely to lend in low-income areas.
Given the extent of exclusion in the SME sector and the criticality of the sector for the economy, banks urgently need to step up lending to the sector. For evaluating loan proposals and for facilitating SME financing, banks would need to employ low-cost and quick decision-making alternatives. The use of credit scoring models can go a long way in facilitating lending decisions by reducing costs and increasing service levels.
The author is deputy governor, Reserve Bank of India(Excerpts from the keynote address at the Training Workshop on Credit Scoring Model for MSE Lending, in Mumbai on November 29, 2013)