Credit Score, by Multiple Choice; Where credit scores are rare, banks are using a psychometric test developed at Harvard to help lend to small-business owners

December 30, 2013

Credit Score, by Multiple Choice

By SARAH WHEATON

No credit? No problem — just take a test.

That’s the message being delivered to more than 70,000 small-business owners in developing countries where credit ratings are rare and many potential entrepreneurs keep their money in cash rather than bank accounts.Banks in 16 countries are using a psychometric test to predict future behavior — specifically, whether someone will pay back a loan. Originally a Harvard doctoral project, the Entrepreneurial Finance Lab’s test has increasingly won the confidence of risk-averse bankers in places where, many economists believe, credit bottlenecks are severely stunting growth.

Now, a new partnership with MasterCard has potential to speed the model’s proliferation.

In the United States and other mature economies, assessments by multiple credit agencies based on a lifetime of bill payments and account balances help determine with relative confidence whether to give an individual or business a loan.

But the lack of such data in much of the rest of the world creates a “massive inefficiency in emerging markets,” said Bailey Klinger, 34, the chief executive of the Entrepreneurial Finance Lab. Banks have money to lend, but even profitable small businesses often cannot access it, choking growth.

In wealthy countries like the United States, small- and medium-size enterprises are typically responsible for about half of business activity and almost two-thirds of employment gains. In poor countries, such enterprises, on average, account for only about 17 percent of spending and a third of new jobs.

In 2006, Mr. Klinger was studying this problem, known as the “missing middle,” with Prof. Asim Khwaja at Harvard’s Kennedy School of Government. They struck upon a technique some companies have long used to screen potential employees.

For Jhonathan Darwin Montes Mendoza, a 40-minute test led to a $1,500 loan last year to buy Christmas-themed towels, curtains and other decorations ahead of the holiday rush for his market stall in Lima, Peru. Mr. Montes’s score gave Banco Interamericano de Finanzas confidence he would pay back the loan — even though he had been in business for less than a year, with no credit history.

“You can’t give a loan to someone without knowing if they have psychological problems,” said Mr. Montes, 23, in Spanish, perhaps not fully understanding what the test was measuring. Though similar to tools used by psychologists to assess I.Q., define personalities or screen for addictions, the bank’s test was intended to measure the traits at the core of entrepreneurship: fluid intelligence, business skill, integrity and attitudes.

After paying back the first loan, Mr. Montes is on a second round, paying down a $2,500 debt. The finance lab calibrates the test for each country where it is introduced.

The lab’s model asks questions that do not necessarily have a right answer; using an algorithm, it aims to predict whether an individual is likely to default based on how the answers relate to one another.

For example, to assess their sense of personal control over outcomes — which tends to correlate with loan repayment — respondents might be asked to rate how much they agree or disagree with the statement: “I believe in the power of fate.”

Another question on risk tolerance might ask them to choose between opposing responses with equal social desirability, such as: “I plan for every eventuality,” “I’m in between” or “Planning takes the fun out of life.”

There are some unexpected findings: Optimism and self-confidence are good signs among seasoned entrepreneurs, but high levels in younger business owners do not bode well, statistically.

And the math and reasoning questions meant to measure fluid intelligence can also assess integrity — of the loan officer. Too many correct answers can reveal that an applicant was coached.

The small-business loans have proved to be a “good revenue source” for Banco Interamericano de Finanzas, the fifth-largest commercial bank in Peru, where they have increased by about 50 percent, said Hugo Palomino, its director of commercial products. Over the last year and a half, repayment rates on loans made with the entrepreneurial finance lab’s model have been about the same as those that used a traditional assessment.

The big difference for the borrowers is that under the traditional model, those who did manage to get a loan with minimal credit history would pay about 60 percent interest, said Mr. Palomino. Instead, people like Mr. Montes can qualify for rates of 30 to 45 percent.

Since Standard Bank, Africa’s largest, first adopted E.F.L.’s model in Kenya in 2008, bankers around the world have used it to lend more than $200 million, in average amounts of $7,500, to entrepreneurs who would not have otherwise qualified, the finance lab’s founders say. Now an independent company based in Lima with about 30 employees, the Entrepreneurial Finance Lab has grown with the help of grants, including a $3.6 million prize for being among the winners of a G-20 challenge for small-business financing in 2011.

Still, the program’s early successes are “by no means final validation that the model will really work,” said Peer Stein, a director at the World Bank’s International Finance Corporation, which administers the G-20 challenge grant. The loan test, he said, would “probably have to go through still other iterations.”

Mr. Klinger, the lab’s director, agreed. The test is “not a silver bullet,” he said, adding that the overall value of the portfolio still depended on other aspects of the bank’s operations. “A lot of banks we work with are using that very successfully, and some are using it less successfully,” Mr. Klinger said. Some have stopped using it.

DJ DiDonna, 30, the firm’s chief operating officer, was recruited from Harvard Business School to be, as he put it, the “greedy capitalist.” During the first year, Mr. DiDonna’s job was to tote academic data around the world and tell financial executives that they should “operationalize this inside your bank; sort of hand over your business decision-making with us.”

“That was a tough sell,” he said.

The Inter-American Development Bank and its Multilateral Investment Fund made his job easier in Latin America by helping banks pay for adoption and guaranteeing some of the new loans. More potential to expand will come in January, when MasterCard plans to start a pilot program for small-business accounts at BHD Bank in the Dominican Republic.

Edward Glassman, MasterCard’s group executive for global commercial products, said he had been looking for alternative underwriting models after hearing from banks that they would like to do more with small business, but didn’t have the right tools to do it.

Though the model needs more tweaking to take into account the differences between term loans and credit cards, Mr. Glassman said, “with the emergence of electronic payments, the whole transition from cash to electronic — which is sweeping the marketplace around the world — this is a very logical fit.”