A Silhouette Painted in Finance

The Big Ideas: Innovation is constantly making the business world adjust to New technology—So what’s ahead?

Credit Finance
By: Karen-Janine Cohen
August/September 2011
Original LINK

Can lenders evaluate whether someone can pay back a loan by examining their character? Bailey Klinger, and his partner Asim Khwaja developed a way to do just that.

Bailey Klinger, who grew up near Vancouver, was all set to launch a career in business when he took a college course in international development. “From day one, the class really captured my interest and caused me to turn on a dime,” he says.

It was the depth of world poverty that made Klinger switch gears. “Other problems start to pale in comparison to global poverty…and the impact if solutions can be found,” he says. “I remember in one class thinking about the numbers, about India and China…fix a few small things and you can have an impact on hundreds of millions of lives in a short amount of time.”

Hoping to attend graduate school at Harvard University, Klinger, now 32, sought opportunities that would help him stand out among the throng of similarly inspired applicants. He got a chance to go to Peru through Canada’s International Youth Internship Program where he was paired with the Peruvian Banking Association.

Klinger now has something that might make an impact. After completing both his master’s degree and PhD at Harvard’s Kennedy School of Government, he has come up with a method of evaluating the credit worthiness of small-and-medium-sized business owners in developing countries that is attracting interest.

The credit assessment tool, developed by Klinger and Harvard public policy professor Khwaja, lets lenders use a variety of psychological tests to evaluate whether a would-be borrower is a good risk. While Western bankers might view such a tool as a nice addition to traditional analysis, which relies on such things as credit scores and financial statements, it could prove to be much more valuable in Africa and in the Americas’ developing nations, where accessing verifiable financial background information can be more challenging.

The problem mostly affects small and medium sized business owners that have a harder time procuring money than do bigger firms. Yet, say international development experts, it’s the SMEs (small and medium sized enterprises) that generate jobs and are the incubator for the businesses that grow into national powerhouses.

Part of the problem is that evaluating customers costs banks money. In the absence of traditional credit scoring assessments, banks may have to send representatives in person to stores and offices to tally receipts, check inventory and evaluate projects. Some lenders may just shrug, and say that a loan’s cost is not supported by its size.

“What [Klinger] is trying to do is a useful way of having a new technology that says, ‘I can pool these risks based on this’…it’s a cheaper way of doing a credit assessment, and then it can get credit to people on a smaller and smaller scale,” says Homi Kharas, a senior Brookings Institution fellow.

So how exactly does it work? It adapts tried and true psychological tests developed over decades by industrial psychologists and often used by hiring managers. Applicants answer a number of questions, including some designed to indicate honesty and character. Their configuration also looks for traits such as fluid intelligence and business skills, and evaluates an applicant’s ability—and willingness—to repay loans.

“It’s not psychometrics, and personality measurement in a traditional sense,” Klinger says. It also focuses on the traits that make good entrepreneurs. “We put those two together and applied it to the problems.”

Klinger got the idea while working on a Harvard project examining the South African economy. Everything seemed to come back to constraints on small business growth, he says. Klinger and Khwaja focused on access to finance. They needed something relatively inexpensive that didn’t take too long and could be scaled up. A number of possible evaluation strategies, including DNA and lie detector tests, were looked at. They ended up coming back to those personality and character-profiling tests used by big employers.

In 2008, they founded the Entrepreneurial Finance Lab at Harvard. While still affiliated with the Harvard lab—now called the Entrepreneurial Finance Research Lab Initiative, Klinger and Khwaja spun off their own business. Klinger, who settled in Peru, runs an eight-person office from Lima.

In November, EFL was a winner of the G-20 SME Finance Challenge, a competition that looks for the most innovative ways of increasing SME funding. EFL will share in the $528 million committed to help winners further develop their models.

Their program has been tested on more than 2,300 borrowers in seven countries. According to the partners’ research, their assessment did as well, or better, than did traditional assessments in predicting who would pay back the loan.

South Africa’s Standard Bank is using the tool in four African countries to expand finance access for small businesses, says Klinger, who will speak at the Federacion Latinoamericana de Bancos (FELABAN) Annual Assembly, a yearly gathering of Latin American, U.S., and global bankers in Miami in November.

Mexico’s BBVA Bancomer is also testing the EFL credit valuation. In Mexico, SMEs create seven of 10 jobs, says Eduardo Alexander Marquez-Padilla, of the bank’s SME Commercial and Risk Strategy division.

“Traditional credit valuation…does not allow us to reach certain segments such as newly established SMEs and entrepreneurs,” he says. If the pilot program works, he adds, it will be expanded.