Business Lending vs. Consumer Lending

I think most people understand quite well that business lending has a very different risk profile than consumer lending, but maybe it is not always readily obvious why that is.

Probably the biggest driver of consumer underwriting is wages or income, followed by someone’s overall debt load. People can borrower increasingly more consumer debt so long as they have the income to support it.

A person’s income is relatively easy to figure out, since for most people it is a recurring paycheck about every two weeks. And someone’s debt load is easy to figure out, since most consumer debt is reported to a credit bureau and that debt can be seen on a credit report. This commoditizes information on individuals, and makes it easy to create decision making criteria for a large population since we all share these similarities of a regular paycheck and a credit report.

Businesses differ greatly in all of these characteristics. While the revenue and net income of a business matter a lot, it is far harder to predict the recurring nature of that cash flow. Businesses don’t get a steady paycheck every 2 weeks like average wage earners. A hotel might see an enormous amount of revenue in the summer, and little revenue in the winter. On the other hand, a snow removal company will see a lot of revenue in the winter, and no revenue in the summer.

We can’t create a one-size-fits-all approach to business lending, because the source of revenue and recurring nature of it differs greatly from business to business. Comparing two different businesses isn’t like comparing two different people. It is like comparing two different species.

Businesses also don’t have a robust credit report. Some agencies attempt to create a credit report for businesses, but it is hard to commoditize this information for reasons we just discussed. This would also require all lenders to report business debt to these agencies, which isn’t something customary and it is a practice that would be subject to a lot of debate. Business borrowing often goes beyond simple bank-debt, so even knowing what bank-debt is outstanding still does not give us enough information to decide whether the business can handle another loan.

There are patterns and systems that can be used to underwrite businesses, but they aren’t as fine-tuned as the models used to underwrite consumer debt. And more importantly, in every circumstance of business lending, there is responsibility on the lender to understand the source of revenue for each business. This will require some research and special reporting tools.

Take for example the hotel operator. The lender will need to obtain a special market report for the area hotels to see what average room-night stay costs, and whether there is substantial seasonality. But for the snow removal business, a lender’s research will differ. Now the lender will need to be more concerned with what contracts the company has secured, and what the company has to fall back on if there is not much snow this season.

Because business revenue doesn’t have the same predictability as a wage earner collecting a paycheck, the underwriting differs and the structure of the loans will differ too. This is why a different set of specialists are required for business loan underwriting, and why it presents a uniquely different risk to the financial institution.