Business Credit Scoring--A New Approach.

Credit scoring models have been used in the consumer credit market for quite some time. Based on the success of these models in assessing and calibrating risk, business credit providers are increasingly using scoring systems in decisioning. Should companies develop these systems in-house or use an outsource provider? The challenges that credit managers face in developing in-house systems lies in building adept models with limited resources. Adaptive credit scoring systems offer an attractive solution, utilizing a broad range of data and proven scientific methodologies on an outsourced basis.

Scoring Roots

Historically, businesses sold to individuals they personally knew had the willingness and ability to pay. As businesses became larger and as the number of new customers grew, there was a need to establish a more systematic and efficient method for understanding the risk they assumed. The solution they found was scoring.

Credit scoring has become a successful method of appraising and standardizing consumer receivables. Lenders have used scoring tools to segment and price the various classes of their credit portfolio, to establish pricing and to monetize these assets. The capital markets have been able to better understand the risk involved in these monetizations due to the calibration and standardization provided by credit scoring. In turn, the capital markets, particularly the securitization markets have been able to utilize more accurate assessments of credit loans, ultimately leading to lower borrowing costs.

Although credit scoring has enjoyed expanded usage among consumer lenders, business credit providers are in the early stages of adoption. According to a recent study conducted by the Credit Research Foundation, fewer than 30 percent of the companies surveyed were using credit scoring models. The same group also forecast that this rate would increase to 70 percent within five years. Many agree that the challenge will be to transfer what has been learned and proven in the consumer space to the business credit applications.

Today, companies involved in business credit follow some process to approve credit. It may be a formal model, an informal set of procedures, or a combination of the two. These procedures usually establish a set of quantitative and subjective hurdles (which are often applied inconsistently) and are designed to weed out risky buyers. Some credit scoring systems have gone a step further and attempt to minimize the overall risk of company portfolios while maximizing profitability.

Although quantitative factors drive most credit scoring models, credit managers layer various subjective considerations into final credit decisions and procedures. They must balance multiple, and sometimes conflicting, business objectives, such as minimizing costs per applicant, reducing the risk of bad debt and maximizing the company's profits. In order to balance these objectives, the credit manager often applies nonscientific considerations or art to the assessment.