The Surprising Use of Credit Scoring in Small Business Lending by Community Banks and the Attendant Effects on Credit Availability and Risk

Abstract

Working Paper 2009-9 March 2009 Abstract: The literature has documented a positive relationship between the use of credit scoring for small business loans and small business credit availability, broadly defined. However, this literature is hampered by the fact that all of the studies are based on a single 1998 survey of the very largest U.S. banking organizations. This paper addresses a number of deficiencies in the extant literature by employing data from a new survey on the use of credit scoring in small business lending, primarily by community banks. The survey evidence suggests that the use of credit scores in small business lending by community banks is surprisingly widespread. Moreover, the scores employed tend to be the consumer credit scores of the small business owners rather than the more encompassing small business credit scores that include data on the firms as well as on the owners. Our empirical analysis suggests that credit scoring is associated with increased small business lending after a learning period, with no material change in the quality of the loan portfolio. However, these quantity and quality results appear to vary depending on the way in which credit scores are implemented in the underwriting process. JEL classification: G21, G28, L23 Key words: banks, small business, credit scoring I. Introduction Commercial bank lending to small businesses has received a great deal of research attention over the past two decades. The overriding issue in this literature is one of credit availability, given that small firms have historically faced significant difficulties in accessing funding for creditworthy (i.e., positive net present value) projects due to a lack of credible information. Small businesses are typically much more informationally opaque than large corporations because small firms often do not have certified audited financial statements to yield credible financial information on a regular basis. As well, these firms typically do not have publicly traded equity or debt, yielding no market prices or public ratings that might suggest their quality. To address the informational opacity problem, financial institutions use a number of different lending technologies (e.g., Berger and Udell 2006). One lending technology that has recently received considerable research attention is small business credit scoring (SBCS). This technology confronts the opacity problem by combining personal financial data about the owner of the business with the relatively limited information about the firm using statistical methods to predict future credit performance. Consumer credit scoring (CCS) has been widely used for many years in retail credit markets (e.g., mortgages, credit cards, and automobile credits), but SBCS is a more recent phenomenon. Most large U.S. banks did not adopt SBCS until the mid-1990s due to concerns regarding firm heterogeneity and nonstandardized loan documentation (e.g., Mester 1997). As discussed below, some banks instead use the consumer credit scores of small business owners to evaluate small business loan applications. The application of CCS to small business lending has not been previously studied. The empirical literature studying the effects of SBCS has documented significant favorable effects of this lending technology on small business credit availability, broadly defined. Specifically, the adoption of SBCS is empirically associated with 1) increases in the quantity of lending (Frame, Srinivasan, and Woosley 2001, Frame, Padhi, and Woosley 2004, Berger, Frame, and Miller 2005); 2) more lending to relatively opaque, risky borrowers (Berger, Frame, and Miller 2005); 3) lending within low-income as well as high-income areas (Frame, Padhi, and Woosley 2004); and 4) lending over greater distances (DeYoung, Glennon, and Nigro 2008). (1,2) See Berger and Frame (2007) for a more comprehensive review of these studies. While the extant research provides some important information about SBCS, this literature is hampered by the fact that all of the empirical studies are based on a single survey of the largest U. …