Smaller banks and credit unions have a long and cautious history of lending to potentially risky borrowers. Understandable, as borrowers with a poor credit history are at a higher probability of default. Yet by limiting their credit box rather than pursuing a risk-based lending strategy, smaller banks limit their potential for growth. By instituting risk-based loan pricing strategies, lenders can adjust their lending criteria to accommodate an overall higher profit margin that ensures profit gains largely offset losses.
What is Risk-Based Lending?
Risk-based lending (or risk-based pricing) in the credit market represents the strategy of offering various interest rates and loan terms to borrowers based on their creditworthiness. Risk-based pricing models consider many factors to determine the loan amount and borrower’s credit risk.
Unlike financial institutions’ approach to consumer lending, which primarily relies on personal credit scores, creating a risk-based pricing strategy for business lending must encompass more than just the credit report. A risk-based pricing strategy allows community financial institutions (CFIs) an opportunity to help high-risk borrowers overcome a history of delinquencies and a lack of good credit. In addition, CFIs can improve their market share without affecting risk management.
Creating a Risk-Based Pricing Strategy
Establishing a risk-based lending strategy allows a CFI to offer lower interest rates to low-risk borrowers while widening their methodology to include higher-risk borrowers hoping to repair their credit rating. Borrowers are more likely to accept higher interest rates with the understanding the loans are a means to an end—obtaining money to grow their businesses and eventually securing lower interest rates. The pricing strategy involves setting different interest rates and loan terms based on the business’s creditworthiness.
Although risk-based lending can be advantageous for CFIs, financial institutions must base their pricing strategies on reliable algorithms and monitoring systems to avoid losing profitability due to large overhead costs, such as underwriting and collection. In addition, CFIs can be in legal danger if they violate equal credit opportunities and compliance requirements.
Because risk-based pricing is complex, lenders require a sound strategy: due diligence, comprehensive planning, and a control system. Lenders are better able to assign fair and appropriate loan pricing and therefore more effectively meet the credit needs of their customers when equipped with borrowers’ business information, credit histories, and industry benchmarks.
Risk-based Pricing Parameters
While consumer credit weighs significantly in a business borrower’s risk analysis, it is not the end of the story. Risk-based pricing lenders can tailor their strategies to include additional parameters for business borrowers, including debt-to-income ratios, business location, industry, and other key metrics. In addition, lenders should be able to retain their risk tolerances and loan risk management strategies. Then, as borrowers’ financial creditworthiness improves, risk-based lending strategies can identify and reward those borrowers with better terms.
CFIs’ strength and reputation rely on offering business loans to borrowers who might not qualify at other financial institutions. So, a structured risk-based pricing strategy can help meet customer needs and attract more business customers.
According to the National Credit Union Administration (NCUA), a risk-based lending strategy should have:
- A plan that acknowledges the inherent hazards of risk-based lending and the resources and staff to manage the risk
- Policies and procedures to define the parameters of the risks
- Information systems in place to monitor and analyze the results of underwriting, operations, and pricing decisions
- A quality control system that provides feedback on compliance to accounting and legal guidelines
- Recognition parameters for borrowers performing well or poorly
Determining Credit Risk for Business Borrowers
While consumer borrowers rely on FICO scores for obtaining consumer loans, a business borrower may not realize their business credit scores are separate from their personal credit scores and have no impact on their personal credit score. Although most lenders must ask for permission to access consumer credit scores when determining eligibility, a business credit score is available for viewing at any time.
One way to effectively evaluate the financial strength of small businesses is by employing a tool such as Biz2Credit’s BizAnalyzer. Once the applicant enters the required information, BizAnalyzer analyzes the business’s creditworthiness based on the CFIs risk-based lending parameters. The tool benchmarks the risk profile of a business against the lending criteria of financial institutions.
It’s helpful to have every critical metric in one dashboard so lenders can access a business’s cash flow summaries, industry benchmarks, and how the owner’s personal credit score affects their business finances. CFIs typically use tools like the BizAnalyzer to determine a small business’s financial strength and benchmark its risk profile against lending criteria.
Not all tools are the same, so the information requested and delivered may vary. If you use the BizAnalyzer, this is how it works.
Business owners submit financial information such as:
- Description of business assets (Real Estate, Equipment, Inventory, Accounts Receivable)
- Business Name
- Personal Credit Score
- Age of Business (Year 1, 2, 3, etc.)
- Loan Amount Acceptable (Min $, Max $)
- Business Legal Structure (Sole Proprietorship, Corporation, LLC, Partnership, Non-Profit)
- Residence Status (Own, Rent, or Neither)
- Home Value
- Monthly Mortgage/Rent Payment
- Average Monthly Expenses (Other)
- Average Monthly Income
The information is then benchmarked against the lending criteria of 150+ financial institutions and the risk profiles of industry peers. Based on a weighted formula of recent underwriting trends, the tool generates an overall score (on a scale of 1-100%) of the level of risk that a business presents to the lender. The assessment is then broken out by the following sections, based on information provided by business owners: Personal Credit Score, Debt-to-Income Ratio, Time in Business, Industry Risk, and Corporate Risk. The BizAnalyzer also recommends products and services tailored to help increase the business’s credit score and improve their odds of securing funding.
CFIs then create a snapshot of a business’s risk level by identifying and evaluating the following:
- Revenue, operating costs, debt service, and the liability of the business
- Comparison of stated income versus revenue reflected in bank statements
- Tracking insufficient fund charges levied on business
Finally, the BizAnalyzer tool can be used to automatically calculate the additional debt capacity of the borrower to assist in the lender’s risk-based pricing strategy. Using tools like these will help you create a holistic business credit strategy and increase your presence in the marketplace.
Meta: By instituting risk-based loan pricing strategies, lenders can adjust their criteria to accommodate more borrowers and ensure profit gains largely offset losses.