Strategies for Reducing Small Business Credit Risk

Scott Anderson, CEO, Northeast Member Business Services - The Point
October 4, 2004

Small business lending (SBL) is a growth business for many credit unions. Small business loans are relatively high yield, diversify credit risk, and create opportunities to cross-sell to business owners and their employees. It's an ideal market for credit unions, and you can expect to see greater participation in this attractive line of business.

This opportunity, however, comes with certain risks. Even the largest, most experienced financial institutions incur delinquency and loss. Despite those risks, financial institutions have made hundreds of billions of dollars through SBL—a testament to the profitability of this business. Credit unions can combine proven risk-management practices with appropriate pricing to succeed in this market. Here are five proven methods used by top lenders to help ensure that your credit union has a positive SBL experience:

Target Marketing. Not every small business is a good SBL prospect. The key is to know which business fits your risk parameters. Start by making loans to "established" businesses. A minimum of two years in operation is a good yardstick. These businesses present significantly lower default risk than those in operation less than two years. Second, experienced lenders do not sell to "higher-risk" industries unless they can manage that risk. In such cases, sell an SBA-guaranteed product to reduce credit risk to an acceptable level.

Credit Scoring. Small business credit scoring (SBCS), once considered a black art, is now the mainstream method for assessing repayment risk on loans up to $250,000. It's used by more than 90% of the nation's top lenders because it's fast, cost effective, and accurate. SBCS doesn't eliminate risk. Instead, it tells lenders what they can expect for delinquency/write-off chances. This means that a lender can accurately price and reserve, based on the business's "score."

Risk-based Pricing. Pricing for risk is important to be fair and competitive, and to earn what will be needed to cover downstream losses. Fortunately, the tools are built into the latest SBCS models. Alternatively, lenders can create a matrix of their own to meet the goal.

Small Business Administration (SBA) Express Program. This program has made it easier to apply for an SBA guarantee. The key to success of the program is its incorporation of SBCS as an approved underwriting methodology, and its fast turnaround (less than one day at SBA). The SBA is seeking to expand credit union participation, and most credit unions can qualify within three to six months of starting their SBL program. But remember, SBA is a lender of last resort so don't expect to use the Express Program with all of your loans (25% to 30% would be a reasonable expectation).

Personal Guarantees. Personal guarantees are critical to SBL success. NCUA regulations no longer require these in certain cases, but experience shows they remain essential to recovery of SBL loan losses because it's very difficult to cost-effectively liquidate SBL collateral, and the guarantee is critical to recovery. The fact is, more than 70% of U.S. business is made up of service companies and retailers, which have mostly accounts receivable and inventory for collateral. It's not possible to monitor such collateral on an SBL, and in any case, it will be gone (collected) by the time a lender can react.

If you make SBLs you can expect losses, like any other lending operation. Successful small business lenders use the techniques and technologies described above to make sure their SBL programs are sound. Credit unions, especially those new to the game, should do the same. This way, they can help the small businesses in their communities in a safe and profitable way.

Reprinted from The Point for Credit Union Research and Advice at http://thepoint.cuna.org.