If the nation's economic slowdown persists, banks' small-business loan portfolios could be stress-tested as they have not been in a decade. Much has changed in that time, notably the use of credit scoring by lenders. Computerized credit scoring has revolutionized lending to the nation's smallest businesses, those with revenues of less than $1 million. The use of credit scoring for making loans to these companies has saved lenders huge amounts of time and money. That has led to intensified competition and has encouraged the use of sales and marketing methods more familiar in mortgage, consumer and especially credit card lending.But credit scoring in the small business sector has not weathered a full business cycle, and that could mean some unpleasant surprises ahead. Indeed there have already been a few disappointments.It is unknown how many banks have early warning systems in place that are sophisticated enough to detect problems in the notably larger small-business portfolios that have resulted from the widespread use of automated credit scoring. "You can make every effort to minimize surprises, but you can only do so much on small loans. It really is very time consuming and expensive to closely monitor every single loan on the books," notes Charles Wendel, the president of Financial Institutions Consulting in New York.A number of banks have begun making credit-scoring adjustments by raising the acceptable threshold scores. Meanwhile, those loans already on the books should be getting more "hands-on" scrutiny, he says."Successful banks are on top of issues like slower payments or lower deposits," he said. "They intervene quickly to restructure or maybe move a loan over to a secured lender," such as a finance company. The cost factor has always been the rub for lenders in catering to the smallest of businesses. "Basically, these loan are loss-leaders, with the required deposit relationship as the key to making them work. You have to use technology to make any money in this area," Wendel says.But smaller firms—microbusinesses, as economists call them—are critical to the health of the nation's economy, with millions of workers. Also, the best mom-and-pop outfits can grow into successful major enterprises and take their banks along with them.Credit scoring seemed to ease this quandary for lenders by bringing costs down and turning small-business loans into something like credit card lending. But that has led to some new concerns."You can't tiptoe into this market, because it has become a scale business," says Lawrence W. Cohn, bank stock portfolio manager for BBT Partners, a hedge fund. "To be profitable, you have to pursue marketing efforts on a large scale, with a lot of mailings, and you have to credit-score on a major scale," Cohn says. In addition, players have to be "big enough to take a hit."At the same time, "in order to rely on automation, underwriting criteria have to be tight, and that limits the size of the potential market," said Cohn.In short, thousands of small businesses may have to be screened to uncover the relative handful that will meet underwriting criteria. By extension, that means many rejection notices. "Small businesses and entrepreneurs tend to hate credit scoring. While they need the financing, what they want is a real relationship," says Frank W. Anderson, a bank and financial analyst based in Plano, Texas.Computerized credit scoring has nevertheless spread rapidly among lenders in the past five years. And many lenders assert that their "scored" portfolios—those based on the new credit-scoring systems—compare well against the older "judgment" portfolios.For banks in particular, credit scoring has evolved as a powerful competitive tool that has helped them put aside the industry's dowdy image of being inflexible. Credit scoring helps them compete with the likes of such giant commercial finance competitors as CIT Group Inc., and such nimble next-generation niche players as Reservoir Capital Corp. of Baltimore, which caters to high-tech companies. A loan approval process once requiring days or even weeks can now sometimes be completed in merely a matter of hours. The rapid turnaround time has helped lenders snare new business while at the same time freeing up loan officers to work on the relationship side of the business. On-line software can enable a loan officer on the road to process a loan application from a client's office or even from a car, using a laptop computer and cellular phone. With advanced credit scoring techniques, some major small business lenders last year were "auto-approving" up to two-thirds of business loans under $100,000.Meanwhile, efforts such as those of Bank2Business.com, jointly developed by Fair, Isaac & Co. of San Francisco and Baker Hill Corp. of Carmel, IN, have leveled the playing field for small banks, which could rarely afford to develop such systems on their own.Banks need to be above $10 billion of assets "before they can start to look at this kind of technology," according to Jim Hill, president of Banker Hill.But beyond the productivity improvement and image enhancement there is the undeniable fact that such underwriting methods have not been tested across a full business and credit cycle. "None of us has been through an economic downturn since we began using credit scoring, and that, as well as the fact that any lender who forgoes it will likely be at a competitive disadvantage, has led some banks to rely on it too heavily," Michael R. James, executive vice president of Wells Fargo Bank, San Francisco, warned at an industry conference a year ago.While credit scoring is an excellent lending tool when it is used properly, "some people don't know what they are doing," he asserted. Wells Fargo is among the nation's largest small-business lenders and has deployed computerized credit scoring methods longer than most institutions. It has been refining the technique since 1991. "Clearly, a weaker economy will have an impact on some borrowers," Allen W. Sanborn, president and chief executive officer of the Risk Management Association, formerly known as Robert Morris Associates, cautioned his membership in January.As a banker, Sanborn did stints at the old BankAmerica Corp. and Shawmut National Corp., now part of FleetBoston Financial Corp. Both those banks experienced serious small-business loan portfolio problems in the last economic downturn, in the late 1980s. Most banks remain very confident about credit scoring, says Wendel. "Should they be? At this point there is no reason not to be, but it is absolutely true that it has not been tested in a down cycle."On the other hand, if credit-scored small-business loans are really akin to credit card loans, "those have been tested and there are actuarial models that can be relied on," he said.Ultimately, banks big enough to have developed their own proprietary credit-scoring systems—custom-fitted to their particular customer base and armed with the benefit of their lending experience—can be expected to outperform many rent-a-model systems. "The better banks understand the methodology being used and they haven't just said to a vendor 'do this for us and we'll check back with you in a year.' They actively manage the process," he says.Of course, he adds, every business slowdown brings fresh surprises, and "it's impossible to anticipate everything."

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