Small business lending has always presented a unique challenge for financial institutions. Unlike large corporations with established borrowing histories, many small businesses and sole proprietors have little or no traditional credit history, making it difficult for banks to accurately assess risk. As a result, many creditworthy businesses are denied financing simply because they lack sufficient data in conventional commercial credit files.
Alternative data is beginning to change that equation. By incorporating non-traditional indicators—such as business registrations, utility records, licensing information, and operational history—lenders can develop a more complete picture of a business’s financial stability. As banks look for new ways to responsibly expand small business lending, alternative data is becoming an increasingly valuable tool for identifying qualified borrowers who would otherwise be overlooked.
Small businesses’ ability to access credit has long been a challenge. This is because banks have historically lacked the capability to efficiently evaluate the credit risk of small businesses and single proprietorships. A recent article in American Banker, written by an executive at LexisNexis, elaborates on this challenge:
According to a forthcoming study based on our statistical analysis on small businesses’ credit histories, almost half of the small businesses tracked by traditional commercial credit bureaus have only one line of credit, and usually it’s a credit card. These businesses are called “thin files,” because they simply don’t have enough credit history to rank as a full-file portfolio. And then there are the countless other small businesses considered “no file” that lack any line of credit. They have perhaps never applied or been approved for credit.
The intriguing thing is that among these two groups, those with thin files and those with no files, there are many businesses that would still present “good risks” to credit providers. As banks refocus on lending to small businesses, it is not just about keeping bad risks from entering the credit system. It is also about expanding the market by finding those firms that would be likely to repay but that have been on the fringes finance because they lack traditional credit bureau records. There are millions of such businesses out there.
The article goes on to introduce alternative data (information not captured in traditional business and consumer credit bureaus) as a possible solution to this challenge.
So what is alternative data? Generally, alternative data consists of the “footprints” a business leaves while conducting business. These are often intuitive. For instance, did they go through an annual registration process at the state level? Did they develop contacts or apply for a special business license? Did they set up a business telephone line and utilities? Who are the people connected to the business, and what footprints did those individuals leave?
These intuitive data points can support traditional credit risk evaluation processes in a variety of different ways:
For example, in the consumer space, if someone has lived in the same house for decades, they have what we call “address stability,” a type of alternative data that predictably shows that somebody is likely to pay back a loan or credit card bill. It paints a picture of a good risk. There are similar dynamics in small business: details of a small business’ history, length of activity, firmographics and other basic “data footprints” are solid indicators as to whether its credit history is thin or nonexistent.
While alternative data is not used by a majority of banks offering small business loans today, I expect that this will rapidly change as banks start taking more cues from alternative small business lenders like Kabbage and OnDeck Capital.
Alternative data is not intended to replace traditional commercial credit reporting, but it can significantly enhance the lending process for businesses with limited or nonexistent credit histories. As digital footprints become more comprehensive and analytics continue to improve, financial institutions will gain greater confidence in evaluating small businesses beyond conventional credit scores. Banks that successfully incorporate alternative data into their underwriting models will be better positioned to expand lending opportunities, grow their small business portfolios, and compete with fintech lenders that have already embraced these innovative approaches.
Overview by Alex Johnson, Director, Credit Advisory Service at Mercator Advisory Group
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