EconSouth (Third Quarter 1999)


CURRENT ISSUE


Some Benefits of Credit
Scoring Begin to Surface

s banks have adopted automated customer services and faced more intense competition over the past decade, some banks, for better or worse, have lost many personal touches. Today, banks steer customers to ATMs or a Web site, employers directly deposit pay, and individuals and businesses apply for loans electronically.

Customers are becoming accustomed to these developments, and while some customers like them, others are bothered. Credit scoring is a development of recent decades that has separated bank customers and banks' credit decision makers. Credit scoring was initially applied to credit cards and then mortgage lending, but more and more banks have begun to credit score loan applications by small businesses during the 1990s. The scoring process uses borrower information and a computer model to evaluate a borrower's prospects of repaying a loan.

Small business credit scoring and its advantages and disadvantages for various groups are topics that have been debated in recent years by the banking industry, consumer and small business advocacy groups, and those in the political arena. Three researchers at the Federal Reserve Bank of Atlanta recently shed some light on the impact of credit scoring when they evaluated small business lending in low- and moderate-income (LMI) areas in Southeastern metropolitan areas. A summary of their research is presented in this issue of EconSouth.

Dispelling credit scoring myths
Contrary to beliefs that credit scoring might bias lending decisions against small businesses in LMI areas, the Atlanta Fed's research findings show that it might help small business owners seeking loans. The research indicates that small business owners in the Southeast who apply for loans at big banks may have a better chance of getting a loan from a credit-scoring institution than from a nonscoring institution. If each bank has a branch in the neighborhood, the credit scoring impact is small. If neither bank has a neighborhood branch, the scoring bank is much more likely to make a larger loan.

Are the findings a surprise?
While this research represents the first systematic approach to examining the bias claims against credit scoring in small business lending, I must admit that I am not surprised by the researchers' findings. In fact, the findings help to confirm what I have believed for some time: credit scoring can provide a more even playing field for small business owners in LMI areas since the practice eliminates much of the subjectivity and guesswork long associated with lending to small businesses.

During this decade, many banks have realized that credit scoring can be a less costly and more consistent way to evaluate small business loans. And if research like this recent work from the Atlanta Fed can be borne out in a national context, it might help to convince banks that don't credit score of the potential lending opportunities they are missing in LMI areas. It may also help show consumer and small business advocates that credit scoring is not the evil that some of them have assumed.

But there are other questions raised by credit scoring's application to small business lending. What effect does credit scoring have on borrowers with less than perfect credit? How accurate are the models? Will their use allow active secondary markets for these loans to develop? Will the cost savings credit scoring brings to the lending process be passed on to borrowers? Clearly, more research is needed to fully explore the use of small business credit scoring in the United States. However, based on these initial results, it appears that the negative effects of credit scoring that many have claimed cannot be substantiated.

By B. Frank King, vice president and associate director of research of the Federal Reserve Bank of Atlanta

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