SME RISK MANAGEMENT
Edward I. Altmana
NYU Salomon Center, Leonard N. Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012, USA
Group Credit Risk, Royal Bank of Scotland, Gustav Mahlerlaan 10, 1000EA Amsterdam, The Netherlands
Credit Management Research Centre, Leeds University Business School, Leeds, LS2 9JT, UK
Within the commercial client segment, small business lending is gradually becoming a major target for many banks. The new Basel Capital Accord has helped the financial sector to recognize small and medium sized enterprises (SMEs) as a client, distinct from the large corporate. Some argue that this client base should be treated like retail clients from a risk management point of view in order to lower capital requirements and realize efficiency and profitability gains. In this context, it is increasingly important to develop appropriate risk models for this large and potentially even larger portion of bank assets. So far, none of the few studies that have focused on developing credit risk models specifically for SMEs have included qualitative information as predictors of the company credit worthiness. For the first time, in this study we have available non-financial and ‘event’ data to supplement the limited accounting data which are often available for non-listed firms. We employ a sample consisting of over 5.8 million sets of accounts of unlisted firms of which over 66,000 failed during the period 2000-2007. We find that qualitative data relating to such variables as legal action by creditors to recover unpaid debts, company filing histories, comprehensive audit report/opinion data and firm specific characteristics make a significant contribution to increasing the default prediction power of risk models built specifically for SMEs.
JEL classification: G33, G32, M13
Key words: SME lending; Credit Risk Modeling; Bankruptcy; Small Business failure
Corresponding author. E-mail address: email@example.com,
Address: CMRC, Leeds University Business School, LEEDS, UK
The Basel Capital Accord and the recent financial crisis have provided renewed impetus for lenders to research and develop adequate default/failure prediction models for all of the corporate and retail sectors of their lending portfolios. The Basel II definition of financial distress, 90 days overdue on credit agreement payments, is the operational definition for major lenders. The literature on the modeling of credit risk for large, listed companies is extensive and gravitates between two approaches (1) the z-score approach of using historical accounting data to predict insolvency (e.g. Altman 1968) and (2) models which rely on securities market information (Merton, 1974). In retail lending, risk modeling can be undertaken using very large samples of high frequency consumer data and combinations of in-house portfolio data (e.g. payment history) and bureau data from the credit reference agencies to develop proprietary models.
In the past, retail lending was mainly synonymous with consumer lending. More recently, following the introduction of Basel II, an increasing number of banks have started to reclassify commercial clients from the corporate area into the retail one. Although this decision may have been originally motivated by expected capital savings (see Altman and Sabato (2005)), financial institutions have soon realized that the major benefits were on the efficiency and profitability side. Banks are also realizing that small and medium sized companies are a distinct kind of client with specific needs and peculiarities that require risk management tools and methodologies specifically developed for them (see Altman and Sabato (2007)).
Indeed, small and medium sized enterprises are the predominant type of business in all OECD economies and typically account for two thirds...