Comment: Say It Proudly, Our Bank Doesn't Do Credit Scoring

As community banks look for an edge in their ongoing battle for customers, most can tout one basic advantage they have over big banks: they do not do credit scoring.

Credit scoring started as a smart way of cutting down on the cost of putting loans on the books. If a bank could develop a profile of experience that would indicate whether a borrower was likely to pay back the loan or not, it would be able to apply these patterns to new loan requests and avoid the tedious job of individual credit evaluation on each application.

At first, credit scoring became useful in unexpected ways. Bankers found that if they posted the criteria for receiving a loan, and people who thought they would never qualify for a loan saw that they could meet these qualifications, the bank would be able to get a new bankable credit on the books that it might not get otherwise.

So banks ran ads listing the qualities they wanted, giving points for each and letting consumers know they would be approved automatically if they met a certain score. (One bank I know of even stated: "Extra points for neatness on application.")

But as time passed, the basic value of credit scoring became its efficiency. Bankers reported that a human never looks at loan applications of $50,000 or less. They are all done by the credit-scoring procedure.

Credit scoring has other advantages. Minorities often praise it, as the computer program is color-blind and only looks at the numbers, not the face, color, or nationality of potential borrowers.

But it also makes lending rigid.

A borrower may have had only one bad financial experience in his or her career, but credit scoring programs simply do not make exceptions.

Community bankers, however, tend to look at more than just the borrower's credit score. Indeed, because of this individual attention, a community bank often will make a perfectly bankable loan to the borrower when a larger organization's computer would deny the loan.

Banks that refuse to apply credit scoring should not be shy about using this to their advantage. And don't just take my word for it. Edward G. Boehne, retiring president of the Federal Reserve Bank of Philadelphia, said in a recent address at the University of Delaware that small businesses often do not realize that they are making a choice between different kinds of credit when they choose their type of lender.

"New small businesses have not experienced a recession in which their financials deteriorate, thereby making it difficult to pass a credit-scoring model," Mr. Boehne explains.

If a borrower uses a commodity type loan, the bank charges a break-even price period by period. But that means the borrower cannot expect to get a concessionary rate in bad times. "Thus technology will impact not only the type of loans being offered, but also their pricing," the Fed bank president concludes.

Considering the source of the comments, this is powerful stuff for bankers trying to fight the giants with their automatic lending procedures.

Looking in the eyeballs as well as at the borrower's statements has always been important to community bankers and to borrowers who want a relationship instead of an automatic loan. Now, in their marketing explanations, community bankers can add Mr. Boehne's warning: that in bad times the relationship and the willingness to be flexible can help keep a borrower's business alive.

Mr. Nadler, an American Banker contributing editor, is a professor of finance at Rutgers University Graduate School of Management in Newark, N.J.