Blended Credit Scoring Helps Manage Portfolio

CU360
April 21, 2009 | COMMENTS

Keeping a sharp focus on a small-business credit portfolio can be challenging. Credit scoring, once prohibitively costly for small businesses, is an increasingly popular tool. But not all scores are alike, notes Business Credit magazine. The greatest accuracy comes from a blend of information on the business owner and the business itself.

Small businesses are volatile, and their creditworthiness can be relatively hard to assess. An early indication of trouble can help determine if it's time to reduce risk by imposing more stringent conditions on credit. But where will the first indication of small-business credit difficulties surface: in a commercial or a personal file?

Many credit issuers consider one limited measure: the owner's personal consumer-credit information. Other small-business creditors watch for signs of trouble by scoring and monitoring commercial credit information on the business itself. For risk managers, a score that blends personal and commercial information brings optimal results, meaning more "good" approval rates and fewer "bad" accounts, and confidence to increase credit lines and loans.

In a recent study, Experian analyzed credit reports and other information on roughly 50,000 small businesses. The study also analyzed the owners of those businesses. The goal was to find the best tool for predicting small-business failure.

Very rarely—in only a fraction of 1% of the studied cases—did problems come to light on both commercial and personal credit fronts in the same quarter, the study found. That's one reason a blend of both commercial and personal data provides the best early warning system for small-business credit problems.

Advocates of relying solely on consumer data might point out that small-business owners often look and act like consumers. Forty-six percent of small businesses use personal payment cards, and many enterprises fail to separate business and personal expenses.

Indeed, an internal analysis of Experian's database shows a strong correlation between the creditworthiness of the business and the business owner.

Many banks currently use consumer data exclusively when evaluating creditworthiness of small businesses, according to a SBA study assessing the use of credit scoring by financial institutions.

A score based on a business owner alone, or the business on its own, is better than no score. But relying on one or the other may leave risk managers with a blind spot. Unlike consumer scores, blended scores are designed to predict business performance. The consumer score uses personal information to predict consumer performance. On the other hand, the blended score evaluates the personal information on the owner as it relates to business performance. Solely tracking business credit, however, is no panacea.

Problems almost never come to light on both commercial and personal credit fronts during the same quarter. When blended scores are validated, they typically outperform commercial-only or consumer-only scores by 10% to 20%. That allows a risk manager to do one of two good things: increase approvals without increasing losses or keep approval rates the same and reduce losses. The blended score helps credit managers maximize the bad accounts that are rejected while not increasing the rejection rate of accounts that actually would be good. In addition, it can help manage riskier accounts by appropriately adjusting credit limits or repricing credit to reflect risk.

Blended scores give creditors the best view of an individual business. Using both blended scores and other risk-management tools, you can optimize your portfolios for better results.