I admit that like many of my fellow data scientists and analysts, I encountered credit risk modelling for SMEs quite late in my career, after having spent several years developing credit risk models for the retail and the corporate segments.
I was fortunate enough to have gained experience developing credit risk models for the Small and Medium Enterprise (SME) segment for several types of lenders, including universal banks, banks serving niche segments, credit card issuers that issue cards to SMEs and also settle SME transactions, factoring companies and credit insurers. Each SME lender has a unique perspective on the credit risk posed by SMEs and can access different data pertaining to each small or medium enterprise. I can therefore provide a fairly comprehensive picture of modelling SME credit risk through the insights gained while working with a plethora of SME lenders.
A common mistake when modelling the credit risk of SMEs is trying to fit SMEs either into retail or into corporate credit risk methodologies whereas the SME segment deserves a unique approach, which is different from these two segments.
Based on my experience, when modeling the credit risk posed by an SME, four factors must be reviewed and considered:
- Key individuals - in most small and medium enterprises, decisions are made by a single person or by a handful of key individuals. Unlike a large corporate in which key decisions are governed by the board or are driven and controlled by structured decision-making and decision approval processes, small and medium enterprises manage centralized decisions and those decisions are critically dependent on specific, named individuals. Any changes pertaining to those key individuals such as retirement, personal financial distress, illness or even an interpersonal conflict that somehow arises out of the blue can negatively impact the business viability of the SME. Consequently, SME models typically attempt to quantify the risk relating to these individuals such as their domain experience, how long they have been with the business, whether or not changes in control had taken place, whether any of the key individuals is distressed financially etc. Typically, the parameters that are related to this type of risk include number of key individuals, their age, their experience, etc.
- The market segment in which the SME operates - it is necessary to understand which specific market segment the SME operates in, what is the precise role of the SME within that segment and where is it focused geographically. Unlike corporates that typically operate in a number of segments or that cover a diverse geographical territory and that also have the means to penetrate new segments as market conditions change, SMEs are typically tied to the specific segment in which they currently operate. An analysis of that specific segment can tell us a great deal about their risk. For example, a local grocery store will be threatened if a large supermarket with a strong national brand opens nearby. The local grocery will have very few means to fend off such a threat. In a similar manner, a travel agent may be at risk as more people buy travel services online and completely bypass brick-and-mortar travel agents.
- Revenue generating activities and cost structure - corporates can get through tough times through mergers, acquisitions, raising of additional capital. SMEs, on the other hand, are completely dependent on their ongoing revenue stream and cost structure. For a small or medium enterprise, any material change in revenues or in costs will immediately impact cash flow and materially increase credit risk. Here are some some patterns that are early indicators of risk:
- An SME in which revenues are steadily increasing over a lengthy period of time.
- An SME that grows too rapidly and does not have the administrative infrastructure in place to support such growth.
- An SME which is dependent on a small number of clients, each of which accounts for a large portion of revenue.
- An SME that depends on a client base that is volatile, such as tourists.
In order to effectively address this risk, a credit risk model for an SME needs to take into account revenue changes, while offsetting the impact of one-off events and of adjusting for any seasonal effects. In addition, the credit risk model must consider the customer base of the SME, looking at number of customers, customer diversification, customer demographics, etc.
- Financials - as with any business, the financial condition of the SME needs to be considered. Balance sheet, P&L and cash flow must be analyzed. That being said, the financial statements of small and medium enterprises are frequently unreliable as a source of information for assessing credit risk. In many emerging economies, audited financials cannot be fully trusted due to lax accounting standards. Frequently, audited financials are only available several months after the balance sheet date, making them outdated. In some cases, the owners of the small business have a tax incentive to leave no profit or cash with the company, taking into account that the personal wealth of the owners can be used to provide additional capital if necessary. In such cases, the financials will again be misleading. Due to these shortcomings of standard financial statements, other sources of objective and recent financial information should be considered. Possible alternatives that can provide updated financial information for assessing credit risk include bank balances, cash on hand, tax reports, etc. In our experience, key financial factors that impact credit risk are the financial leverage (defined as the ratio between credit to overall revenue), savings, the mix of credit instruments used by the SME as well as overall trend in taking up credit.
To summarize my view on developing a valid credit risk model for SMEs, I believe that the following three guidelines should be applied:
- Refrain from treating the SME segment as a special case of a retail or a corporate sub-segment and select a unique SME-only approach.
- Ensure that all key risk factors are considered, including an assessment of the SME's key individuals, the market segment in which the SME operates, an analysis of revenues and costs and finally financials.
- Try to use several independent sources of information and avoid relying on just a single information source.