The possibility of an economic downturn is fueling concerns about the quality of small-business loans.

Experts warn that blind reliance on computerized credit scoring and overzealous marketing may have planted potential disasters in many banks' loan portfolios. Questionable underwriting practices could come back to haunt lenders when the economy inevitably slows down.

"An economic downturn ... will shake out some of the craziness that is in this industry," said Michael R. James, executive vice president of business banking at Wells Fargo & Co., a leader in the small-business market.

There are not yet many signs that small-business loans have started to deteriorate. A survey of 10 of the largest lenders by the trade group Robert Morris Associates found that from Dec. 31, 1998, through June 30, nonperforming assets declined to 1.27%, from 1.66%, and net chargeoffs to 0.43%, from 0.47%. Delinquencies increased but only by 2 basis points, to 1.74%.

The strong, long-lasting economic growth cycle has fired up the entrepreneurial sector, creating a healthy appetite for credit that has coincided with banks' willingness to boost their portfolios.

However, the economic boom will not be permanent, and many fear that portfolios are sure to suffer. The current crop of small-business credits, products of banks' newfound aggressiveness and nurtured by systematic credit scoring techniques, have yet to be tested by hard economic times.

RMA president Allen W. Sanborn said that the last downturn spelled disaster for small-business portfolios at two now-defunct banking companies where he had worked: the old BankAmerica Corp. and Shawmut National Corp., now a part of FleetBoston Corp.

"We are nine years into what is regularly a seven-year cycle ... so unless Alan Greenspan is God, your portfolios will be tested again," Mr. Sanborn said last week at a small-business conference sponsored by RMA and American Banker. "We will tell in the next downturn how good you really are."

Bankers agreed that one area sure to come under scrutiny is credit scoring.

Employing credit scoring to underwrite small-business loans, if done judiciously and skillfully, tends to strengthen portfolios, several bankers contended. Virtually all small-business lenders rely on credit scoring models to evaluate a borrower's finances and the owner's personal credit history.

The computerized process has made underwriting remarkably efficient, reducing what could take as long as 12 hours or more to as little as 25 minutes. It is no surprise that banks have made it a large part of their small-business lending.

KeyCorp, for example, "auto-approves" 65% of its business loans of under $100,000, according to Michael A. Butler, vice chairman. Eighteen months ago the Cleveland-based banking company used credit scoring to approve loans of up to $35,000. The limit is up to $100,000 now and is expected to rise to $250,000 in 2001, Mr. Butler said.

"We're a big believer and a big user of credit scoring," he said.

Steven Bauer, national risk manager of business banking at Bank One Corp., argued that scoring often is a less risky way to underwrite small-business credit than relying on a loan officer.

"We can prove that our scored portfolio will, month-in, month-out, outperform our judgment portfolio," Mr. Bauer said.

But there is a potential dark side. During one conference presentation, a tally of raised hands showed that virtually no lender present had been using credit scoring for more than five years. Mr. James of Wells Fargo said that while credit scoring is a good tool in skilled hands, it is still relatively new and has yet to face the test of a weakening economy.

"None of us have been through an economic downturn since we began using credit scoring," Mr. James said. "A lot of our scorecard data came out of a very good environment."

The increased efficiency provided by credit scoring -- 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, Mr. James warned.

"Some people don't know what they are doing," he said, adding that Wells Fargo has been credit scoring since 1991. "If you don't understand credit scoring, don't do it."

The dependence on credit scoring has not gone unnoticed by regulators. During a recent examination by the Office of the Comptroller of the Currency, Bank One's practices came under close scrutiny, Mr. Bauer said. Though Bank One passed muster, he said, the OCC "is on the warpath" regarding overreliance on credit scoring.

"There are too many organizations that are going too far too fast without the proper infrastructure," Mr. Bauer said. "We are so glad we invested in doing this properly."

Using credit scoring responsibly entails not being afraid to alter terms after a loan is booked, and repricing if the riskiness of a loan increases, said James Nelson, director of lending and finance at Robert Morris Associates.

"You have to know how to react and change your scoring if things start to go bad," he said.

Indeed, if small-business lending causes credit problems for banks, it will be because portfolios are not adequately priced for risk, Mr. James said.

"We are not good at increasing the price when risk increases," he said. "You have to price for risk at the point of origination, adjust pricing over the life of the loan, and get away from 'one price fits all.' "

Mr. James offered some startling examples of the ways lenders have been marketing small-business loans. In an effort to keep tabs on its competition, Wells Fargo tracks mailings sent out by other lenders, a process Mr. James referred to as "buying small businesses' mailbox contents." These mailings offered rates guaranteed to remain at prime "forever" and credit lines of up to $250,000, no questions asked.

"We don't do deals of under $250,000 without financial information," Mr. James said. "If we don't, you shouldn't."

Some acknowledged that sales personnel sometimes urge credit officers to book loans without taking a close look at risks.

"I can't tell you how much pressure we get from salespeople who say, 'All my borrowers are good borrowers,' " Mr. Bauer said.

Others admitted that their portfolios were growing faster than their risk management skills.

"Our marketing got ahead of our ability to manage risk," said Robert M. Kottler, executive vice president of retail and small-business banking at New Orleans-based Hibernia National Bank. He described its small-business portfolio as "stable," but added that the bank had to take steps in the past to strengthen risk management.

"Our portfolio got to the size where we couldn't manage individual transactions for risk," he said. "We had to manage it more like our consumer portfolio ... as a broad group of loans, rather than individual ones."

Banks preparing for an economic downturn must carefully target which businesses they market to, stress-test their portfolios, and be prepared to sell loans that show early signs of deterioration, said Bank One's Mr. Bauer.

"We have got to run through some what-ifs, and position ourselves for contingencies," he said.

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