United States. Congress. House. Committee on Small.

The effects of bank consolidation on small business lending : joint hearing before the Subcommittee on Taxation and Finance and the Subcommittee on Government Programs of the Committee on Small Business, House of Representatives, One Hundred Fourth Congress, second session, Boston, MA, March 4, 1996 online

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Online LibraryUnited States. Congress. House. Committee on SmallThe effects of bank consolidation on small business lending : joint hearing before the Subcommittee on Taxation and Finance and the Subcommittee on Government Programs of the Committee on Small Business, House of Representatives, One Hundred Fourth Congress, second session, Boston, MA, March 4, 1996 → online text (page 20 of 21)
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reserve in the event that they have dropped out of the program and the loans have been paid off. The
primary answer is that a key provision in maintaining the structural integrity of the program is that the bank
can only gain access to the funds in their earmarked reserve to cover losses on loans made under the
program. If a bank knew that it could ultimately withdraw funds from the reserve after dropping out of the
program, this might create an incentive for the bank to put conventionally bankable loans under the
program reasoning that in such a situation it would ultimately get all or most of the money back. By
contrast, if the only way that a bank can gain access to the funds in the reserve is to cover losses from its
program loans, the only way that a bank can ultimately get any advantage from the program is to use it for
its intended purpose; as a flexible tool to help the bank expand its markets by taking more risk that it
otherwise could.

The program contains a formula for addressing the effective dropping out of the program by the bank. If
for a consecutive 24 month period the amount in the reserve fund continuously exceeds the outstanding
balance of all of the bank's enrolled loans made since the beginning of the program, MBDC is authorized to
withdraw any such excess to bring the reserve down to an amount equal to 100% of the outstanding
balance. As a practical matter, this formula would only come into play for a bank that has dropped out of
the program Even if a bank has been inactive for a long period, if it begins making loans during the 24
month period, the aggregate outstanding balance would generally quickly exceed the reserve. The formula
is thus intended to give MBDC the ability to withdraw funds from the reserves earmarked for banks that
have effectively dropped out of the program, but to do it in a manner that in no way jeopardizes the
protection that the reserve provides for any loans still outstanding.

Eartv Stage Incentives

How does a bank proceed in the early stages of its participation in the program, before a substantial reserve
has been built up? Many banks will understandably have a tendency to be rather cautious initially. As the
reserve begins to build, and as the bank gains more experience under the program, the bank may gradually
become more aggressive, expanding its margins that much further.

Even if a bank is unfortunate enough to have one of its early loans in the program get into trouble, it is
likely to be some time before the loan actually defaults, and by that time presumably the bank will have a
portfolio of loans and have built up an adequate reserve. Nonetheless, there is some extra risk attached to
these early loans made before substantial reserves have accrued.



234



In order to assist a bank to build up the reserve more rapidly and to address risk issues in the eariy stage;! of
a bank's participation in the program, two special features have been included in the program. The first
applies to the first $2 million of loans that a bank makes under the program. This feature provides that
MB DC will contribute a greater portion to the reserve. While the minimum and nun rimiim payments for
the borrower and the bank would remain the same, MBDC, rather than simply matching 100% of the
combined total of the borrower and the bank, will instead contribute an amount equal to 150% of the
combined total of the borrower and the bank. Thus, in the minimum case, the borrower contributes 1.5%,
the bank 1 .5%, and MBDC 4.5% for a total of 7.5%. In the maximum case, the borrower would
contribute 3.5%, the bank 3.5%, and MBDC 10.5% for a total of 17.5%. The first special feature is
designed to help build the reserve more rapidly, and to give the bank an extra incentive to begin to use the
program.

The second special feature applies to the first $5 million of loans that a bank makes under the program. If
one of those loans suffers a loss and at the time of the loss there is not enough in the reserve to fully cover
that loss, the bank would initially be able to withdraw all of the amount in the reserve at the time of the
loss, to cover the loss as much as possible. If the bank then continues making loans under the pr ogr am and
begins to build the reserve back up, the bank would be allowed to withdraw from the reserve at a
subsequent time in order to fully cover the earlier loss. (The only restriction is that the amount
subsequently withdrawn to cover the earlier loss cannot exceed 75% of the amount in the reserve
immediately prior to such subsequent withdrawal). Thus, even at the beginning of its participation in the
program, the bank has the comfort of a portfolio insurance effect, because h knows that if in the long term
its losses are kept to a reasonable level, it wfll be fully protected against loss, and the bank will not suffer
due to unlucky eariy losses.

The Process for a Bank To Sign Up for the Program

The state and MBDC have approved a master form of Agreement to be separately entered into between
MBDC and each bank that wishes to participate in the program. Entering into this Agreement does not
commit a bank to make any loans under the program, but does spell out the full and official parameters that
apply if a bank makes loans, and the obligations of MBDC and the bank under the program.

Consistent with the entire approach to the program, the process for a bank to participate is being kept
simple and routine. In addition to the Agreement, MBDC is utilizing a half-page application form to obtain
information on a depository institution's year-end commercial and industrial loans outstanding, and a copy
of its latest balance sheet for statistical purposes.



235



Reliance Upon the Lend ers and The Market ... ,

Tbe Capital Access Program is structured to give lenders maximum freedom to make a broad category of
Impropriate for themselves and their customers. We in turn are relying upon the financial •n^rtutions
enrolled to act responsibly in terms of the letter, intent and spirit of the program. If and when in MBDCs
judgement the program is being abused in any way. we may terminate the program for new loans for that
institution (existing loans of course are still covered). We expect that this termmauon authority wul not be
used.



JOHN J.LaFALCE. New York



236



Congress of the Bnited States

House of HeprestntatiotB

iiwti Congress

Committee on £mall Business

2361 "Rjuburn Douse Office Building

TOashmflton, B£ mil-Ill)

Apnl30. 1996

Christopher C. Gallagher, Esq.
Gallagher, Callahan and Gatrell
P.O. Box 1415
Concord, New Hampshire 03302-1415

Dear Mr. Gallegher:

Thank you once again for taking the time to testify before our joint Subcommittee hearing on bank consolidation
and its effects on small business lending. Your testimony was a great source of information for us.



As was mentioned during the hearing, time constraints prevented us from asking certain questions and going into
greater detail on others. We also understand that a lack of time may have prevented you from responding in full.
We would greatly appreciate it if you would take some lime to review the following questions and answer them
in as great detail as possible. Your answers will be pnnted in the official record of the hearing's proceedings.

1 . In his written testimony, Mr. Aloise of the Bank of Boston lists "credit scoring" as one of several bank
initiatives that are pending to enhance credit availability to small businesses. In testimony before the
Small Business Committee, however, we have heard that "credit scoring" is not helpful to many small
businesses — in particular start-up companies - who simply do not have the data to meet the requirements
of "credit scoring." First, would you please explain the process of "credit scoring" for the record in as
much detail as possible. Also, would you please comment on whether you believe "credit scoring" will
enhance or curtail credit availability to small entrepreneurs and why.

2. Relatedly, what do you believe would most enhance credit availability to small entities?

3 What are your views on the 1993 small business disclosure rule which requires banks to annually report

all loans made under $1 million? In your opinion, does it help small businesses obtain capital? While
no longer likely, if Congress were to pass banking regulatory reform this year, would you support
retaining this disclosure rule?

Once again, we thank you for your contribution and look forward to your response.

Sincerely, ^ / J / ^^

LIND^MITH PETER G. TORKILDSEN

tion and Finance

Up*



Chairwoman, m Chairman.

Subcarflmitte#on Taxation and Finance Subcommittee on Government Progran




Ranking

Subcommittee on Taxation and Finance



237



Gallagheh, Callahan 6c Gaeteell

Phofessionai Association

214 Nohth Matn Street

P.O.Box 1413

Concorjd, New Hampshibe 03302-1415



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603-228-118X
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May 7, 1996



The Honorable Linda Smith

Chairwoman

Subcommittee on Taxation and Finance

The Honorable Peter G. Torkildsen

Chairman

Subcommittee on Government Programs

The Honorable Martin Meehan

Ranking Member

Subcommittee on Taxation and Finance

Committee on Small Business
United States House of Representatives
2361 Rayburn House Office Building
Washington, DC 20515-6315

Dear Madame Chairman and Members of
the Subcommittees:

Thank you for your kind words and for the opportunity to
respond to your guestions, all of which are extremely important.

My responses are attached hereto in numerical order.

Very truly yours,



Christopher y. Gailagher



CCG/jlb
Enclosure



238
RESPONSES



RESPONSE TO QUESTION 1.



Credit scoring is the application of computerized scoring models to the process of
underwriting loans. It is based upon a range of variables including previous credit
delinquencies. It works. While there is no way to predict the credit performance of any
one individual, operating in the context of a number of loan decisions, one can measure
and predict with some accuracy the level of risk associated with certain groups of
borrowers. Scorecards include tabulations of the information available about a borrower,
weighted and analyzed in a way that will produce a predictable level of credit
performance by the group of borrowers which includes the individual applicant.

Credit scoring has been used for years by high volume consumer lenders issuing
credit cards and car loans. In that lending context, actuarially predictable credit
performance is reflected in interest rates, collateralization or other procedures. More
recently, credit scoring has been used in the home mortgage market by primary lenders.
Although underwriting in this sector is more individual than actuarial, the collateral is
standard and costs of foreclosure are predictable. Credit scoring is now encouraged by
Fannie Mae and Freddie Mac, and over time will become the norm.

Applied to small business loans, credit scoring can aid the process of underwriting,
which is by definition, more complex than consumer and home mortgage lending. Credit
scoring is predictive of that component of repayment risk assessment that is based upon
the reliability of the person managing the elements affecting payback. Functionally, in the
underwriting process it resembles what used to be called "character." Small business
loan paybacks are of course based upon a multitude of factors, some well-beyond the
reach and control of the borrower, while others depend upon the borrower's ability to
respond to changing business conditions. Accordingly, credit scoring is not used by
banks as a solitary predictor of small business creditworthiness But since it can
successfully aid analysis of the "personal" factor in small business loan repayment, it is
a useful aid to small business loan underwriting, and its use is increasing.

Credit scoring must itself be "scored" as a help to small business, especially for
those kinds of loans for which the "information" needed to underwrite is incomplete, either
because the size of the loan doesn't warrant a more involved process, or because of the
nature or history of the small business Credit scoring adds efficiency and supplemental
information that can benefit new or very small business borrowers. Recent studies have
demonstrated that credit history (a heavily weighted factor in credit scoring) is one of the
most reliable predictors of loan repayment. Accordingly, because of credit scoring, some
business loans will be made that otherwise might not have been made. It opens doors
that otherwise would have been closed. Because it adds efficiencies to process, credit
scoring is appropriately discussed in a hearing focused upon bank consolidation and
structure. Both issues are about operating efficiencies. Operating efficiently, banks can
devote more resources to their unique and critical role in the small business lending
sector Credit scoring adds to bank efficiency, and thus enhances the reliability and
availability of small business loans



239

Page 2



People who represent, own or are otherwise financially connected to banking or
credit scoring (a group that includes your respondent) will tell you that credit scoring is
beneficial to bank customers, including small business. Nevertheless, there are some
who fear any process that even appears to apply a "black box" approach to bank lending.
Federal Reserve Board Governor Lawrence Lindsey has stated that the use of computer
models to measure creditworthiness will be "overwhelmingly dominant" by decade's end.
His concern was expressed in a 1994 speech to the Boston Bar Association in which he
warned that with credit scoring "we will obtain the fairness of the machine, but lose the
judgement, talents and sense of justice that only human beings can bring to decision
making." In an eloquently ironic development, Governor Lindsey was himself turned
down by the Bank of New York for a retailer's credit card on the basis of his low credit
score (apparently based upon multiple credit status requests). The turndown of Governor
Lindsey elevated his focus and has triggered new scrutiny of the process People
concerned with discriminatory outcomes are particularly suspicious regarding its impact
on minority borrowing, raising arguments similar to those raised regarding the use of SAT
scores to predict college success. The fact is, however, that credit scoring performs as
it advertises. It can predict what percentage of a large group of people with similar
scores will repay their loans. This is valuable information no lender can or should ignore.
Earlier this year, Chemical Banking Corp., now merged with Chase to become the
country's largest bank, stated that it began a year ago using credit scoring to rate
creditworthiness of small business borrowers. It has recently stated that the process
"exceeded" its expectations, adding that credit scoring has sped up its approval cycle,
enabled lenders to spend more time prospecting for borrowers, and thus has helped
contribute to a 44% increase in small business borrowing.

Credit scoring can be a powerful too! for the good. It will enhance small business
lending. As with all powerful tools, its impacts will have to be watched carefully to ensure
that they continue to be appropriate Beyond lending, its utility as a predictor of behavior
is expanding its use into other areas of business that require continuing responsible
behavior by one of the parties. Rents, insurance and other similar relationship
undertakings are proving to be useful transactions for credit scoring. Credit scoring is
here to stay. And if at the end of the day the only persons complaining are those whose
poor credit history, minimal information, and lack of collateral are resulting in difficulties
obtaining small business loa"hs, credit scoring is producing the right result. Our economy
cannot be allowed to relive the results of sloppy bank underwriting that contributed to our
all too recent bank problems and our New England recession. If credit scoring can help
New England avoid another credit crunch, it is a very positive policy development.



240

Page 3

RESPONSE TO QUESTION 2.

Having taken too long to answer the first question, I will be quicker about the
second. Banking needs can be summarized. Banks must consolidate where resulting
structural efficiencies will allow them to operate more effectively. They require constant
review of statutory and regulatory regimes to ensure that resources that could be better
allocated to the proper business of sound banking are not being diverted to unnecessary
compliance activities. They must be allowed to structure their product and service
delivery systems (like credit scoring) as well as their corporate structures (i.e. bank or
bank holding company) in a way that maximizes consumer value by minimizing waste and
other operating inefficiencies. Coupled with geographic and product diversification,
efficiently operating banks, both large and small, can continue to perform the critical
financial services they were designed to perform, and do so with appropriate safety and
soundness. In today's competitive environment, impairments to operating efficiencies that
are no longer compelled by sound public policy are a threat to the stability of banks, and
as a result to the customers who rely upon them.



RESPONSE TO QUESTION 3.

It is too early to tell whether or not this has been useful. I doubt that it has any
bearing at all on capital availability for small business. Whether it will aid in the promotion
of fair lending is unclear. But if it reminds everyone-Congress, regulators, and banks
alike—that small business lending has strong public policy purposes and thus must be
closelymonitored (especially in New England), this requirement may remain useful. If we
are to produce the jobs we need to accommodate the changes we must manage and
absorb to stay competitive in the global economy, we will need a strong small business
environment. Bank lending is critical to that strength. Before the next banking bill
passes, the rule's continued utility should be reexamined.



241










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Congress of the United States

House of HtprcBtntatiotfi

1 01 rti Congras

Committee on £>mall Business

iw Rjo.bum ftouBt Office Building

WMlraigton, BC wii-Kii



JOHN J UFALCE. New York



Apnl 30, 1996



Mr. John P. Hamill

President, Fleet Bank of Massachuse

75 State Street

Boston, Massachusetts 02109-1810

Dear Mr. Hamill:



Thank you once again for taking the time to testify before our joint Subcommittee heanng on bank consolidation
and its effects on small business lending. Your testimony was a great source of information for us.

As was mentioned during the heanng, time constraints prevented us from asking certain questions and going into
greater detail on others. We also understand thai a lack of time may have prevented you from responding in full.
We would greatly appreciate it if you would take some time to review the following questions and answer them
in as great detail as possible. Your answers will be printed in the official record of the hearing's proceedings.

1 . In his written testimony, Mr. Aloise of the Bank of Boston lists "credit scoring" as one of several bank
initiatives that are pending to enhance credit availability to small businesses. In testimony before the
Small Business Committee, however, we have heard that "credit scoring" is not helpful to many small
businesses - in particular start-up companies — who simply do not have the data to meet the requirements
of "credit scoring." First, would you please explain the process of "credit scoring" for the record in as
much detail as possible. Also, would you please comment on whether you believe "credit scoring" will
enhance or curtail credit availability to small entrepreneurs and why.

2. Relatedly, what do you believe would most enhance credit availability to small entities?

3 What are your views on the 1993 small business disclosure rule which requires banks to annually report

all loans made under $1 million? In your opinion, does it help small businesses obtain capital? While
no longer likely, if Congress were to pass banking regulatory reform this year, would you support
retaining this disclosure rule?

Once again, we thank you for your contribution and look forward toy^fcir response.

Sincerely, ^ ft f ^^»

LINDA SMITH PETER G TORKILDSEN

Chairwoman, Chairman,

i on Taxation and Finance Subcommittee on Government Programs




U^-^



Ranking Member*

Subcommittee on Taxation and Finan



243



1. Credit Scoring

There is little question that credit scoring will lead
to greater standardization of small business lending
and the eventual development of a vibrant secondary
market. This will bring about increased lending by
financial institutions to small businesses. The most
widely used credit scoring program in the banking
industry was developed by Robert Morris Associates and
Fair, Isaac. Last year, the Small business
Administration purchased the RMA/Fair, Isaac Small
Business Scoring Services (SBSS) to help administer the
agency's Low Doc Program.

Fleet has internally developed it's own small business
scoring system similar to the RMA/Fair, Isaac Small
Business Scoring Services (SBSS) , which is an
integrated risk assessment and automated credit
application processing system.

Criteria for acceptance is based on an initial set of
empirically derived pooled data scorecards. The
scorecards measure potential credit risk from small
business customers using application, financial, and
credit report information, as well as industry
comparisons using data from RMA's Annual Statements
Studies .

By using the scoring system, institutions can raise
loan acceptance rates, reduce delinquency rates,
improve turnaround time, reduce underwriting costs,
simplify the credit application process, and greatly
enhance the risk management control of their loan
portfolio. By providing significant costs advantages
for evaluating the risks associated with small business
lending, credit scoring will enable institutions to
increase their small business lending volume. As to
the concern of some that "start-up companies" will not
have the information needed for credit scoring systems,
much of the data required is based on personal
financial history and should, therefore, be readily



244



available. Programs such as SBA Low Doc further
enhances the flexibility of scoring systems for the use
in start-up situations.

It is likely that the use of scoring systems, much like
residential housing financing secondary market, will
create the need for programs which address certain
unmet market needs. Overall market access however will
certainly be expanded and enhanced through wider use of
scoring systems.



245



2. What would most enhance credit availability to
small entities?

Obviously, continued economic growth is the best way to
enhance credit availability to small entities.
However, a reduction of overly burdensome regulation,
to which non-bank competitors are not subject to, would
greatly assist institutions in better serving the small
business community. There is little question that
technological advances, such as the use of credit
scoring systems will enable the industry to better
manage risk. Financial institutions will then be
better positioned to maximize lending opportunities and
serve small business more effectively.



246

3. Small Business Disclosure Rule

Beginning this year, banks are reguired to track and
disclose small business lending by census tract to the
banking agency regulators. In March of 1997, the
regulators will publicly release an aggregate amount of
small business lending as reported by institutions they
supervise. However, a growing number within the


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Online LibraryUnited States. Congress. House. Committee on SmallThe effects of bank consolidation on small business lending : joint hearing before the Subcommittee on Taxation and Finance and the Subcommittee on Government Programs of the Committee on Small Business, House of Representatives, One Hundred Fourth Congress, second session, Boston, MA, March 4, 1996 → online text (page 20 of 21)