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Traditional checks may be too strict to serve deserving entrepreneurs and organizations that lack credit history.
Within a traditional credit file, lenders consider the “five Cs of credit” to determine whether a small business is worth the risk for a loan. These include credit history, capacity to repay outstanding debt, collateral, capital and conditions, such as the loan’s purpose or the economic environment. Yet many small businesses seeking funding may not have a traditional credit file, which means their applications would be declined if their bank or credit union evaluated their loan application on the basis of the five Cs.
Small businesses are often among the most valuable members for credit unions, but rigid credit requirements can work against self-funded entrepreneurs and organizations with little or no credit history. This makes it hard for credit unions to increase the number of small businesses in their loan portfolios, leading them to either spend more marketing dollars to attract loan applicants or loosen underwriting criteria to approve more existing applicants.
Instead of increasing marketing spend or taking on riskier loans, credit unions can leverage alternative data to better assess the creditworthiness of small businesses and ultimately expand their portfolios without compromising credit quality.
Alternative data could include information from an applicant’s utility bills, bank account records and social media accounts. Other forms of alternative data include sales records, employee history and even Yelp reviews. Such data sources enable lenders to form a more holistic view of the borrower and make better-informed credit decisions.
The financial services industry increasingly recognizes the value in using alternative data. It is important for today’s credit unions to consider how this data can be used during the origination process, as well as on the portfolio management side of the lending cycle.
Boosting Profit and Reducing Origination Costs
On the origination side, adopting an alternative data strategy can reduce origination costs and boost the profitability of member business loans. For a loan under $50,000, between $700 and $3,500 is generated on interest, while the underwriting costs range between $1,600 and $3,200, according to research from Oliver Wyman. By leveraging alternative data to inform and streamline origination and underwriting, the margin for profit can be widened.
For instance, incorporating alternative data into underwriting can help a loan officer quickly identify a creditworthy applicant and eliminate wasted time sifting through applications that should clearly be declined. Alternative data can also help reduce the time loan officers spend following up with applicants for additional information and documents, further driving down origination costs. As such, the availability of this data proves valuable for members by enabling a simplified application process. Credit unions can pull data from external sources to augment an application, which may mean members need to submit less information and documentation manually.
Managing the Loan Portfolio With Alternative Data
Beyond origination, alternative data is useful for managing the loan portfolio. For example, some sources of data, like sales history or online reviews, may help credit unions identify potential problems sooner. This helps the credit union proactively address a problem before the loan becomes delinquent by modifying the terms of the loan or shoring up the agreement with additional collateral or guarantors. Additionally, using alternative data facilitates risk-based pricing—setting loan rates according to the borrower’s risk profile, grounded in data.
As credit unions begin harnessing the power of alternative data for member business lending, they should track the successes and failures with their portfolios, which will in turn gain them a stronger understanding of the types of loans that succeed or fail within their local communities. From there, credit unions can monitor which sources of data accurately predict loans’ performance. For some loans, online reviews may be the best predictor for success, while for others, sales records and website traffic may hold the most insight. By regularly analyzing the book of loans, credit unions can constantly tweak and improve on measuring loan performance and determine how to best assess credit risk during the underwriting process.
Credit unions can also capitalize on opportunities that would have gone unnoticed without alternative data. A local business may have received multiple online reviews from customers disappointed that popular items are out of stock again. A savvy credit union can recognize that this business may need to hire additional employees or resources to increase production, meaning they are a good candidate for a loan.
Thanks to alternative data, credit unions can significantly expand their member business lending market without taking on undue risk. As a result, more small business owners will be eligible to obtain the capital they need to grow and succeed.
James McHale is SVP/general manager of analytics at Baker Hill, Carmel, Ind.
