Jeff Judy

Jeff's Thoughts - January 27, 2016

When People Aren't People

There was a time, not that long ago, when it was easy to be clear about when we were lending to a person, and when we were lending to a company. As you know, commercial credit has generally been approached very differently from the way we handle loans to consumers.

We maintained that distinction even when the "loan purpose" was very similar. For instance, I might have a business that needs a new truck to make deliveries. And as an individual, I might prefer to drive a truck rather than a car. But getting those two vehicles would entail two entirely separate and different processes.

This seems obvious, so why do I bring it up? Because the distinction is getting blurred in practice by modern, technology-based underwriting practices. And unfortunately, I'm hearing stories of that distinction getting blurred in the minds of credit staff.

The problem stems from the appeal of the small business market. Now, community banks have worked with small businesses for a long time. And for most of that time, they followed a clear commercial credit process with little opportunity for confusion with consumer practices.

But the bigger banks have been trying to find a way to tap small business market. And as more players enter this market, looking for ways to get a return on small business credit, the extension of credit scoring as a major tool in small business credit has made a huge difference.

Traditionally, consumer credit has followed a statistical or actuarial approach. Now we have tools that apply that same approach to the financial analysis of small business credits. But it must be said that "small" is relative. Credit scoring is now being used for credit decisions about loan amounts that dwarf what could be handled by credit scoring in the early days of the practice.

At the same time, credit unions have entered the small business market with their member business lending. And it is only natural, given their very strong history of consumer credit, that sometimes that strong consumer experience (over-) influences how they handle commercial credits.

Put all these influences together and you have a generation of credit officers whose entire experience is in a world where ordinary individuals and small businesses are handled, to some extent, in similar ways. And that makes it easy to forget that the business asking you for credit is not a person, but a different type of legal entity.

Credit staff who blur this distinction put their institutions at risk of legal and regulator action. While we may complain about the rigid rules of consumer credit, the rigidity of those rules also offers us a certain level of protection. If we check all the boxes, we generally are in compliance.

When lending to a business, however, the rules are not spelled out in the same detail. That offers the legal profession lots of room to challenge your practices. "Lender liability" is a fertile field in which to grow credit headaches. Treat that small business too much like a consumer, and when they default on your credit, you may find yourself empty-handed.

Financial analysis of small businesses and consumers will continue on a common path, as larger and larger credits are handled with an actuarial approach. To protect your institution not only from excessive losses, but from additional legal action against you, make sure all your credit staff see the difference between individuals and legal entities, even when the processing of these two markets looks very much alike.