While many banks expect credit scoring to make small business lending profitable, a new study says standardized loan products and centralized underwriting are the real keys to better margins.

In a private study, the Business Banking Board, a Washington, D.C.-based consultancy, joins those advocating a focus on reducing the cost of small business lending by consumerizing those credits.

"Banks tend to treat these loans the same way they do commercial loans, when, in fact, these loans are just like retail loans," said Vikrem Capoor, a consultant at the Business Banking Board. "These people have little distinction between when they're applying for a home equity loan or a business loan."

Mr. Capoor said that, for banks to wring out the profit potential of this market - which study participants say ranges from 8% to 53% return on equity - they must copy consumer lending procedures. These include offering standardized products, centralizing underwriting, and automating the processing function, all in order to reduce the cost of handling credits.

To top off the program, Mr. Capoor said banks should introduce the use of some form of credit scoring and review only those loans that have developed problems.

A retail approach would require that small business bankers accept a certain number of loan defaults as an inevitable cost of doing business, said Alan McIntyre, a consultant at the New York consulting firm of Oliver, Wyman & Co. Ultimately, cost savings and new business generated from this approach would more than pay for any increase in loan losses.

"By trying to achieve a zero-default rate in this segment, banks have created a credit process that is way out of proportion to the size of customers they are dealing with," said Mr. McIntyre. "If the credit is only for $20,000, it doesn't take very long before you've destroyed the profitability of that product."

He advocates centralization of such functions as document preparation, credit analysis, and settlement as the first step in developing a retail approach to small business lending.

"Centralization, per se, won't give you that much of an economic benefit," he said, "but it is a catalyst for getting other things to happen."

Mr. Capoor said standardization is equally important. This includes standardized loan products, application forms, underwriting, and credit standards. By making underwriting standards uniform, he estimated, banks can quickly reject up to 35% of the loan applications that fail to meet standards. This allows the credit department to focus on the remaining applications.

"This takes away the worst elements of character lending and ensures every loan meets the credit standards the bank has established," he added.

Equally important, however, is the manner in which these changes are carried out. The bank must base its system on meeting the needs of its customers; otherwise, the plan may fail even if it is doing many things right.

In one case, a southeastern superregional bank tried to match its competitors' ability to give a preliminary answer on a loan application within 15 minutes by having the customer speak directly to the centralized credit department. Mr. Capoor said the mistake in this approach was that it gave the customer the impression the decision was impersonal and the branch manager unimportant.

"If these changes are implemented properly, it can be totally transparent to the customer," he said.

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