How do you model the credit risk of a small business? The Credit Risk Centre held a 1-day conference to discuss the most pertinent issues of SMEs’ finance and credit risk.

The Credit Research Centre (CRC) responded to the UK government appeal to increase lending to Small to Medium Enterprises (SMEs) by holding a 1-day workshop to discuss the most pertinent issues of SMEs’ finance and credit risk, with a view of setting a research agenda relevant to lenders and regulators. The main focus was on lending technologies and the practicalities of credit risk assessment, as access to credit is contingent on meeting the risk standards of credit providers, especially in the environment of prudent lending.

The Centre is highly regarded among credit risk practitioners, especially in consumer credit area. Since 1997 it has been leading the academic enquiry into most challenging problems. A particular strength is its constant contact with the industry which ensures the relevance and practical focus of the research. The Centre is best known for its biannual Credit Scoring & Credit Control international conference, which provides a platform for presenting the latest developments in the area and a forum for discussion among academic and practitioner communities. The current event was a response to a demand for shorter discussions on specific topics, and it is the first one in the planned series.

The choice of the topic was prompted by suggestions from practitioners. Yet the main decisive factor was the importance of SMEs to the UK economy, as was stressed by Jonathan Crook, CRC Director, in his opening address. This was further emphasised in Jake Ansell’s thorough analysis of the performance of SMEs through the crisis which looked at the period from 2007 to 2010.

An international mix of speakers included leading academics and practitioners. The recurring theme was the informational opacity of SMEs. The majority of small companies are not traded so there is no market information available which would normally form the basis for corporate credit risk assessment. Another standard source of information used for this purpose would be financial statements. But for SMEs the statements are not necessarily audited or complete. The difficulties of SME modelling were highlighted by Paul Orton (Senior Consultant, Experian) in his thoughtful discussion of default definitions for modelling, where he demonstrated the problems even with creating a reliable definition of ‘default’ in SME context.

Further insights from the industry were provided by Rahul Pakrashi who talked about the current practice of Funding Circle, an on-line marketplace bringing together investors and small businesses in need of funds. Academic contributions included the analysis of predictive value of different types of information by Dr Galina Andreeva (CRC) and a new modelling algorithm presented by Dr Raffaella Calabrese (University Milano-Bicocca, Italy).

Yet the discussion went beyond pure technical details of risk modelling. Dr Robin Prager (Federal Reserve Board, Washington DC) analysed a possible impact of regulatory downgrades of banks on their lending to SMEs and did not find that there was a negative impact, since it was downgraded banks’ financial health that was responsible for slower growth in SME lending. Dr Alicia Robb (Kauffman Foundation, US) demonstrated in her Keynote speech that firms owned by ethnic minorities in the US had lower credit scores than white-owned companies, but there was no evidence that this was caused by racial bias in credit scoring methodologies. Minority businesses were also found to be smaller, with higher chances of failure and less reliance on bank financing, which could be attributed to their self-selection out of bank lending as the result of higher expectations of being rejected.

The second Keynote speaker Prof Beck (Tilburg University, the Netherlands) provided an overview of how different lending technologies were used around the world. Both bank and loan-level evidence showed that banks of different ownership structure and with different lending technologies could cater to SMEs. Dr Hideaki Hirata (Harvard University, US, Hosei Business School, Japan) shared the experience of credit scoring application in Japan and difference in ex-post performances between the banks using relationship or transactional lending technologies.

The workshop was attended by more than 60 delegates, including major lenders RBS and Lloyds. It gave a lot of food for thought and brought together researchers and industry representatives interested in the same area. Cross-fertilisation of ideas will definitely be beneficial and we will look forward to future meetings, since there are plans to make the workshop a recurring event.