Credit markets involve three main players: Borrowers, Savers, and Lenders. The role of financial intermediaries (banks, credit unions, community development financial institutions (CDFI), and non-bank financial companies) is to mobilize savings to lend to borrowers. The lender-borrower relationship presents a unique challenge—the “Principal-Agent” problem. This problem arises when a Principal (say a lender) cannot fully observe the actions of an Agent (borrower) who may have conflicting objectives.
Consider the case of a commercial lender (Principal) and small business borrower (Agent). The challenge is to identify ways to align incentives to encourage lending, and lower borrowing costs. The borrower’s objective is to find an affordable loan to boost their business. The lender’s objective is to maximize returns from their loan portfolio. The lender’s challenge is to assess a borrower’s true creditworthiness to properly set loan terms.
Borrowers typically have an information advantage over lenders. They may also have an incentive to conceal vital private information to present themselves as a lower risk to gain better loan terms. Building trust is one solution to the Principal-Agent problem.
Trust benefits both lenders and borrowers.[1] It allows lenders to offer terms more closely matched to a borrower’s true risk profile, reducing the risk of default. Otherwise, lenders might be forced to charge higher risk premiums, offer shorter-term loans, and/or require more collateral.
Borrowers also benefit from building trust. A small business that might have hesitated to make investments under less attractive terms now has access to more affordable funds. Building trust encourages lending and lowers borrowing costs. It expands credit markets, attracting new lenders and formerly hesitant or marginalized borrowers.
Small business borrowers face multiple challenges that make lending risky. These include market, operational, supply chain, regulatory and other risks that can raise the threat of default or impact their ability to generate sufficient cash flow to make timely payments. Since lenders cannot directly observe these risks, they must rely on approximate indicators or “proxy variables” to build trust and establish creditworthiness. Although proxy variables largely depend on the industry, market conditions, and other factors, several standard variables are used by lenders to build their trust in business borrowers:
- Management experience: The experience and qualifications of the management team can be a strong predictor of a small business’s success. This can include experience in the relevant industry, experience in managing a small business, educational qualifications, and a clear understanding of cash flow, managing debt, and making sound investment decisions.
- Financial history: A small business’s financial history, including its cash flow, profitability (gross margins), and debt-to-equity ratio, can be a key indicator of its ability to generate income and repay debt. Cash flow is the lifeblood of a small business, and effective cash flow management is crucial for success. Businesses that carefully monitor their cash inflows and outflows, and have a plan to manage cash shortfalls, are more likely to be profitable and creditworthy. Small businesses that maintain accurate financial records are better able to track their performance and make informed decisions. Good financial record-keeping practices include regular bookkeeping, financial statement preparation, and budgeting. Managing debt effectively is also critical for small businesses. This includes monitoring debt levels, making timely payments, and minimizing interest expenses.
- Market opportunity and sales growth: The size and growth potential of the market in which the small business operates, and its market share can be a significant determinant of its success. This can include factors such as the size of the target market, number of competitors, and the regulatory environment.
- Product or service innovation: The ability of a small business to innovate and offer unique and profitable products or services, and/or lower costs, can help it stay ahead of the competition giving it a competitive advantage that increase its chances of success.
- Customer base and retention: The loyalty and size of a small business’s customer base can be a key factor in its success, as repeat customers can generate consistent long-term revenue streams. Excellent customer service can foster lucrative long-term relationships.
- Operational efficiency: The ability of a small business to operate efficiently and minimize costs can help boost profitability and improve its chances of success. This includes carefully managing expenses, negotiating with suppliers, and finding ways to increase efficiency. For example, businesses that manage their inventory efficiently by maintaining optimal inventory levels, tracking turnover, and minimizing costs, are more likely to be profitable.
Typical proxy variables used by credit rating agencies such as Dun & Bradstreet (PAYDEX Score), Experian Business Credit (Intelliscore Plus), and Equifax (Small Business Credit Risk Score) include some combination of financial statements, credit utilization, payment history, years in business, public records, industry risk, and company size. Financial statements, such as income statements, balance sheets, and cash flow statements can provide valuable insights into a small business’s financial health and performance. Lenders often look at metrics such as revenue growth, profit margins, and debt-to-equity ratios to assess creditworthiness.
Although better known for its consumer credit scoring models, FICO’s (Fair Isaac Corporation) Small Business Scoring Service also incorporates credit data from individuals that control the company especially if the small business is a sole proprietorship or a partnership. Five proxy variables are typically used in standard FICO credit scoring models:
- Payment history: A borrower’s prior consistent payment behavior accounts for approximately 35% of the score.
- Amounts owed: Calculating a borrower’s total debt, debt-to-income ratio, credit utilization rate, and the amount owed on different accounts makes up approximately 30% of credit scores.
- Length of credit history: The length of time engaged in credit utilization makes up approximately 15% of scores.
- Credit mix: A mix of different types of credit, such as credit cards, installment loans, and mortgages, accounts for approximately 10% of scores, and positively impacts scores.
- New credit: Opening multiple new credit accounts in a short period of time can negatively impact scores, and accounts for approximately 10% of scores.
Although standard credit scoring models can be useful for lenders to build trust in a borrower’s creditworthiness, there are serious limitations. Conventional credit scoring models tend to be backwards-looking and to use a one-size-fits-all approach. This can result in inaccurate assessments of creditworthiness for different demographics and categories of small business borrowers. Three new factors are being explored to build trust in business borrowers:
- Social media metrics, such as the number of followers, engagement rate, and sentiment analysis of comments and posts, may provide insights into a business’s brand awareness, reputation, and customer satisfaction. Alternative data, such as rent payments, utility bills, and mobile phone bills could also help build trust in new business owners who may not have established credit histories.
- Environmental, social, and governance (ESG) factors such as a company’s environmental impact, social responsibility, and corporate governance practices, may help build trust in the long-term success of a business and its creditworthiness. Companies with strong environmental performance may be less risky if it makes them less likely to face climate-related impacts or regulatory and legal challenges. Moreover, companies that are more socially responsible might be viewed as more trustworthy and less likely to engage in unethical or illegal behavior. Meanwhile, companies with strong corporate governance practices tend to be more stable and less likely to experience financial distress.
- Psychometric variables, such as the business owner’s risk tolerance, decision-making style, personality traits, financial attitudes, and trustworthiness may provide insights into their ability to manage and grow a successful business.
Some limitations of traditional credit scoring models can be addressed by leveraging AI to incorporate these and other alternative data sources. AI and machine learning techniques can help build trust and significantly enhance credit scoring models in several ways that will be discussed in the next post.
[1] Lenders tend to offer better terms to borrowers that are:
- Honest and provide accurate and complete information about their financial situation, including income, expenses, and outstanding debts;
- Responsive to requests for information or documentation, and that provide required materials in a timely and efficient manner; and
- Able to reliably fulfill loan obligations, make timely payments, and keep lenders informed of any changes that might impact their ability to satisfy the terms of a loan.
Borrowers also need to trust lenders are:
- Reliable and credible, with a proven track record of fulfilling commitments and careful regarding borrowers’ confidential financial information and loan details, protecting borrowers’ privacy and sensitive information;
- Transparent, providing clear and accurate information about loan terms, fees, and repayment options, and responsive in answering questions promptly and addressing concerns or issues that arise during the loan process;
- Fair, impartial, and consistent in their actions and decision-making, applying loan policies and procedures fairly and consistently, and acting without any bias or discrimination based on factors such as race, gender, or religion; and
- Accountable for their actions and decisions, taking responsibility for any mistakes or errors and working to rectify them as quickly as possible.
