K C Chakrabarty: Credit scoring - an effective way to ensure availability
of timely and adequate credit to Micro and Small Enterprises (MSEs)
Keynote address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at
the Training Workshop on Credit Scoring Model with support from IFC for MSE Lending,
Mumbai, 29 November 2013.
* * *
Assistance provided by Ms. Lily Vadera is gratefully acknowledged.
Accompanying chart and tables can be found at the end of the speech.
1. Ms. Jennifer Isern, Manager, South Asia Advisory Services, International Finance
Corporation (IFC); Shri S.K. Dubey, CMD, Canara Bank; Shri H.S.U. Kamath, CMD, Vijaya
Bank; Smt. Archana Bhargava, CMD, United Bank of India; Shri Ashwini Kumar, CMD, Dena
Bank; Shri S.R. Bansal, CMD, Corporation Bank; Shri Sushil Muhnot, CMD, Bank of
Maharashtra; Dr. Deepali Pant Joshi, Executive Director, Reserve Bank of India; Executive
Directors and other senior officials from various commercial banks; Mr. Suresh Sankaran,
Mr. Neil Ramsden and Mr. Cameron Evans, the resource persons from IFC ; colleagues from
Reserve Bank of India; ladies and gentleman! It is, indeed, a pleasure for me to be amidst
you this morning to deliver a keynote address on a very topical issue of ensuring availability
of timely and adequate credit to Micro and Small Enterprises. It is a subject that is very close
to my heart and hence, I am extremely happy to flag off this workshop on credit scoring
models which is fundamentally aimed at capacity building in the banking sector by imparting
practical knowhow to people who are expected to use it in their day-to-day operations.
2. As you are all aware, fostering a dynamic micro, small and medium enterprise
sector for sustenance of economic development is a priority for the policy makers, in both
developed and emerging economies. In India too, Micro, small and medium enterprise
(MSME) sector plays a pivotal role in generating employment, increasing cross - border
trade and fostering the spirit of entrepreneurship. The sector contributes to economic
development in a variety of ways such as creating employment opportunities for rural and
urban population, providing goods & services at affordable costs by employing innovative
solutions and supporting the export initiatives of the country. In fact, it is increasingly being
recognized by the policy makers that if India has to regain its high growth trajectory, it needs
a vibrant MSME sector. However, it is deplorable that despite recognizing a widespread need
for supporting the sector, the progress on the ground is extremely lackluster and the extent of
financial exclusion in the sector is very high. Part of this reluctance of the formal financial
sector to reach out especially to the MSEs arises from their own inability to assess the
potential of companies in this sector. It is in this context that credit scoring models can prove
to be a valuable tool in better understanding and appraising the sector. As you might have
discerned from the schedule, the purpose of today's training workshop is to drive home the
advantages of credit scoring model in decision making for lending to the SME sector and the
bevy of experienced practitioners from IFC would hold technical sessions through the day to
help you understand the nuances of the process. In my address today, I intend to highlight
the problems faced by the sector insofar as accessing institutional finance is concerned, give
an overview of the credit scoring model and attempt to dispel some common
misunderstandings surrounding credit rating and credit scoring models.
3. The statistics compiled in the Fourth Census of MSME sector revealed that only
5.18% of the units (both registered and unregistered) had availed of finance through
institutional sources, 2.05% had finance from non-institutional sources and the majority of
units i.e. 92.77% had no finance or depended on self finance (see Chart-1.1).
A. Constraints in access to finance by micro and small enterprises
4. As I mentioned earlier, the sector has been facing constraints in accessing finance
from the banking sector. This has also partly to do with inadequate penetration of banking
facilities in the remote unbanked/under banked areas that RBI is encouraging banks to
bridge through structured Financial Inclusion Plans. Another issue which is a constraining
factor is the pricing of credit. In our view, the credit pricing for the MSE sector is not very
transparent and also not very affordable. A sample study of the median interest rates
charged to borrowers by select major banks as on March 31, 2013 worked out to 13%.
B. Lack of alternate source of finance
5. The ability of MSMEs (especially those involving innovations and new technologies)
to access alternate sources of capital like equity finance, angel funds/risk capital is extremely
limited. At present, there is almost negligible flow of equity capital into this sector, which
poses serious challenge to development of knowledge-based industries, particularly those
that are promoted by first-generation entrepreneurs with the requisite expertise and
knowledge. Venture /Risk capital is, therefore, often a more appropriate financing instrument
for high-growth-potential and start-up SMEs. However, access to this type of financing is
often not available to them. In the absence of alternate sources of finance, the SMEs'
reliance on debt finance is very high. The availability of debt finance, however, is not
adequate as viability of these small units is a major issue. Besides, the high reliance on debt,
combined with high cost of credit adversely impacts the financial viability of start-ups,
particularly in the initial years, thereby threatening their long-term survival and sustainability.
C. Constraints of banks in lending to the sector
6. One of the major challenges faced by the MSMEs and more particularly, the micro and
small enterprises (MSEs), is access to timely and adequate credit from the banking sector.
The lenders are reluctant to service the MSEs for a number of reasons, the foremost of
which emanates from a general perception amongst banks that the credit risk in lending to
small and medium borrowers is very high. This, in itself, is a wrong notion that I have been
trying to dispel through my presentations supported by hard data. While the headline
numbers of non-performing assets (Gross and Net NPAs) are higher in this segment, if one
reckons the extent of restructuring and write-offs that are resorted to in the medium and large
borrower segments, the credit risk would appear to be much lower in the MSE sector. A
comparative table indicating the extent of NPAs, restructuring and cumulative write-offs in
micro and small vis-à-vis medium and large segments during the last five years is given
below:
The data clearly highlights the fact that in the recent scenario of rising impairment of assets
in the banking sector, it is the MSEs that have demonstrated better credit discipline resulting
in lower impairment.
7. The other reasons why MSEs are regarded as high-risk is on account of insufficient
assets and low capitalization, vulnerability to market fluctuations and high mortality rates.
Information opacity arising from MSEs' lack of accounting records, inadequate financial
statements or business plans also makes it difficult for potential creditors to assess the
creditworthiness of MSE applicants. Besides, high administrative / transaction cost of lending
small amounts also queers the pitch for banks insofar as MSE financing is concerned.
Notwithstanding the merits of the reasons mentioned above, I would say that a major
constraint in the banks' lending stems from the fact that the existing system of banks' credit
appraisal and related processes are not geared to appraise the financial requirements of
MSE sector.
8. Nonetheless, over the years, there has been a significant increase in credit
extended to this sector by the banks. As at the end of March 2013, the total outstanding
credit provided by all Scheduled Commercial Banks (SCBs) to the MSE sector stood at
Rs.6847 billion as against Rs.5276 billion in March 2012, registering an increase of 29.77%.
Despite the increase in financing to the sector there is still a considerable credit gap which
needs to be bridged. In terms of the Report of the Private Sector Investment for MSME Sub
Group under Working Group for the 12th Five Year Plan (2012-2017) the credit gap as a
percentage to total demand is estimated at 56% in 2013-14 for the MSME sector as may be
seen from the table.
9. In the absence of alternate source of funding for the sector, the role of banks is very
crucial in bridging this funding gap. In this context, it is important for the banks to look beyond
their existing customer base and the large corporates and to reach out to the vast number of
micro and small enterprises which are presently deprived of bank credit. Alongside extending
the reach of their banking services, there would be a need to improve and customize the
products offered , fine tune the pricing aspects and enhance the quality and efficiency of
services. For this, banks need to have a proper business plan and delivery model that would
harness the benefits of technology. This would help in planning product delivery and building
lasting customer relationships which will translate into higher revenues. The costs of banking
transactions need to be dramatically reduced just as in so many other fields such as telecom,
after the advent of technology.
D. Need for alternate appraisal techniques
10. Having appreciated the criticality of the sector in terms of its contribution to
employment generation, manufacturing and exports, it is important for us to ensure that
lending to the sector is appropriately stepped up. Here, we need to appreciate that the credit
process in case of micro and small entrepreneurs cannot be identical to that of large
corporations, where the borrower is able to provide detailed information about business plans
and the firm's financial statements and the lender carefully reviews the data using analytics
that are time-consuming and expensive. In view of the relatively small size of the loan, banks
do not find it worthwhile to conduct an elaborate appraisal of SME credit proposals both in
terms of value and profit. Therefore, in order that the banks can quickly conduct appraisal of
SME loan proposals without expending too much resources, it would be imperative to ensure
the efficiency of the appraisal process. An important dimension to efficiency in the context of
lending decisions is the speed with which any individual lending decision is taken. Efficiency
is improved by better evaluation of future payment performance so that the lender is able to
choose whom to accept and whom not to accept.
11. Financial institutions in the developed countries use a number of different lending
techniques to address this challenge and provide funding to small firms. The banks, in these
countries, use a version of a computerized loan-evaluation system, referred to as credit
scoring, to assess would-be borrowers. The credit scoring approach, which is based on use
of computer technology and mass production methods, was originally designed to handle
consumer loans, but are now being used effectively for lending to small businesses by
predicting their potential loan delinquency. Credit scoring offers a modern alternative for the
traditional method of evaluating loans for small businesses where loans were approved on
the basis of the banker's qualitative judgment and the financial condition carried significant
weight in the appraisal process.
12. With a view to expediting the flow of credit to the MSE firms, RBI, as a proactive
measure, issued guidelines in May 2009, advising banks to start using scoring models for
making lending decisions in case of all advances up to Rs.2 crore. However, despite, our
instructions having been issued nearly five years back, we find that use of credit scoring
model in the real sense has not really taken off in India. Our assessment is that perhaps the
lack of conceptual clarity on the subject could be one of the reasons for banks' reluctance in
using the credit scoring model for making MSE lending decisions. In fact, very often credit
scoring is misunderstood or confused with credit rating. In the next segment of my talk today,
I would, therefore, attempt to answer three questions viz. What is credit scoring? How it
works? And what are its benefits?
E. What is credit scoring?
13. Credit scoring is a statistical technique that combines several financial
characteristics to form a single score for assessing a borrower's credit worthiness. The score
ability willingness
does not predict a company's to pay, but rather its to pay in a timely
fashion.1 The probabilities of delinquency, as estimated by the model, are based on the
analysis of previous applicants with similar characteristics. Credit scorecards are "tools used
to predict the behavior of new applicants based on the performance of previous applicants"
(U.S. Comptroller of the Currency, 1998). Scorecards can also be used to predict the
performance of existing accounts, based on past experience of accounts with similar
characteristics.
14. Credit scoring, is a model applied by banks in their assessment and approval or
decline of the loan requests by SMEs. As there is a strong link between the payment
behavior of the business owner and that of the business, SME credit scores usually include
financial characteristics from both the business and the business owner. Credit scoring is
based upon information like how the repayment of the previous loans has gone, what is the
current income level of the enterprise, what are the outstanding debts, if any? It focuses on
the credit history of the enterprise. As part of the process, the lenders see whether the
enterprise/ business owner has the reliability and honesty to repay the loan. It also examines
how the enterprise has used credit before, its record for repayment of bills, including utility
bills, how long the enterprise has been in existence, assets possessed by the enterprise and
sustainability and viability of the activities that the unit is engaged in. Credit scoring model
draws inputs from historical information on the performance of loans with similar
characteristics.
Background of credit scoring
15. Credit scores have been widely used for many years in consumer credit markets
e.g., mortgages, credit cards, and auto loans. The model has facilitated lending procedures
leading to availability of low cost credits and faster decision making yielding significant
growth in consumer credit availability. Owing to the similarities of the small business in terms
of being individual centric, the principles utilized for making lending decisions to individual
borrowers under the credit scoring model were extrapolated to meet the credit requirements
of small businesses. In the mid-1990s, Fair Isaac and Company introduced one of the first
credit scoring models developed exclusively for SMEs, the Small Business Scoring Service
(SBSS). Since then, many SME banks in the U.S., as well as in Canada, the U.K., and
Japan, have implemented some type of credit scoring for SME borrowers.
Difference between credit scoring and credit rating
16. Quite often, I have seen bankers talking about credit scoring and credit rating in the
same breath. Therefore, before I move any further, let me attempt to clarify the difference
between credit scoring and credit rating. I would like to emphasize that these are two entirely
distinct concepts and to be employed in distinctly different scenarios. So what are these
differences? Credit scoring is a statistical technique that combines several pre determined
characteristics to form a single score to assess a borrower's credit worthiness. The score
allocated to any application is the sum of the appropriate weights given by the values that the
included characteristics take for that application.
Any two identical applications will always receive the same score. Credit rating, on the other
hand, is based more on the experience and judgment of the credit officer and uses financial
indicators as key. The objective of scoring is to replicate manual analysis and approval of
loans at a lower cost, with greater speed, while the use of credit rating is reliant on manual
analysis by credit officers to supplement the rating provided by the tool.
17. To put it simply, credit scoring uses a retail lending approach to credit
screening/decision making and is recommended for smaller ticket size loans, where
adequate reliable financial data about the borrower is not available. Credit Rating, on the
other hand, is a more appropriate tool for larger, mid-segment or corporate loans which have
relevant financial data/ business plans that provide the basis for further credit analysis and
information. Again, credit scoring is usually a 100% automated mechanism for screening
loan applicants on the basis of a pre-defined set of parameters while credit rating is a more
subjective and manual method for determining a borrower's ability to repay, based on a
predetermined set of criteria. Further, credit scoring enables clear decision matrix like immediate
approvals, declines or gray area loans, which can be reviewed in greater depth. Declined
loans are "knocked out" quickly while strong proposals get quick approval. Additional
assessment, if any, would only need to be made in respect of gray area loans or proposals
which are neither an unqualified "yes" or an unqualified "no". On the contrary, credit rating
requires a similar level of credit analysis for all loan applications and is more comprehensive
in nature, hence increasing the transaction cost per loan.
F. How scoring model works?
18. The objective of a scoring model is to use a relevant and representative sample to
measure loan performance and then develop characteristics that predict performance. The
resulting model is integrated into the decision making process. A scoring model applies
different weights to the characteristics used to predict the performance. The weights, or
values, measure the influence of that characteristic on the outcome. The weights and the
level of influence are determined by statistical analysis. Only those characteristics that exert
a "significant" influence are included in the final model. The score allocated to any application
is the sum of the appropriate weights given by the values that the included characteristics
take for that application. Under this model, any two identical applications will always receive
the same score, unlike in the manual underwriting where the decision could change from one
lender to the other or also by the same lender depending on the interpretation on a given
day.
G. Benefits of credit scoring
19. When used appropriately, credit scoring can benefit multiple stakeholders, including
lenders, borrowers, and the overall economy. For the lender, scoring leads to process
automation which facilitates process improvements leading to many by products such as
improved management information, control and consistency. It also increases the profitability
of SME lending by reducing the time and cost required to approve loans and increasing
revenues by expanding lending opportunities as lenders can safely approve marginal
applicants that an individual underwriter might reject. International evidence has shown that
credit scoring can assist in overcoming the inherent benefit/cost trade-off that banks face
when deciding whether or not to invest in obtaining information regarding a potential
borrower. A study that was meant to test the credit scoring situation in US estimated that the
cost of evaluating micro loan applications in the US using credit scoring was reduced to
around $100 compared to a range of $500-$1800 prior to the introduction of credit scoring.
The time saving involved meant that banks could focus more time on marginal applications,
existing loans that are showing signs of distress and processing more loan applications. Use
of credit scoring has also meant that the marginal benefits of taking and maintaining
collateral are not justified for small loans.
20. The Bank of England has also acknowledged that there is some evidence of banks
being more willing to lend on an unsecured basis when using credit scoring, which potentially
improves the access to bank finance for very small and start-up Small and Medium
Enterprises.
21. For the borrower, the benefits from credit scoring include increased access to credit
and, in some cases, lower borrowing costs. In its study of SME credit scoring's impact on
access to credit, the Federal Reserve Bank (FRB) of Atlanta found that, in general, the use of
credit scoring increased the amount of credit banks extended to the Small and Medium
Enterprises. It found that banks using scoring were more likely to lend to the Small and
Medium Enterprises that lacked sufficient financial information for approval through
traditional underwriting methods. Presumably, this is due to the inclusion of the business
owner's personal information in the scoring process. The study also found that banks using
scoring were more likely to lend in low-income areas, a fact it attributed to greater objectivity
in the underwriting process.
H. Conclusion
22. Before, I conclude let me re-emphasize that given the extent of exclusion in the
SME sector and the criticality of the sector for the economy, banks urgently need to step up
lending to the sector. For evaluating loan proposals and for facilitating SME financing, banks
would need to employ low cost and quick decision making alternatives. The use of credit
scoring models can go a long way in facilitating lending decisions by reducing costs and
increasing service levels, which can deliver great benefits for both the lenders and MSE
borrowers.
23. I do hope that the technical session by IFC resource personnel would help clarify
your doubts about the credit scoring model and encourage you to adopt a suitable model
which would help accelerate credit flow to this sector. Like all new concepts, there needs to
be a buy-in of the concept at the Top Management level and today's conference is an
attempt in that regard. I believe by the end of today's conference, you would have ample
clarity about the concept and usage of credit scoring model in financing to the SME sector.
The purpose of organizing the Conference would have been well served if we are able to
bring about a change in mindset and willingness of the banks about the way they view SME
financing. If banks consider lending to SMEs to be a viable business proposition and show
the willingness and determination to expand credit coverage to this sector, then credit
scoring models can be employed effectively to achieve this objective in a meaningful way.
This promises to be a win-win proposition for all the stakeholders: the small and medium
enterprises, the lending financial institutions and the overall economy. I once again thank the
IFC resource personnel who have enthusiastically supported our endeavour and wish you all
a successful deliberation.
Thank you!
References
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