Credit referencing, scoring and rating

In a mid-week television show, the conversation soon turned to credit scoring for micro, small and medium-sized businesses.   The context was a headline in the leading business daily to the effect that 60.7% of micro and small enterprises (MSEs) have defaulted on loans in June 2023.  The business daily was quoting a Central Bank Report, the FinAccess MSE Tracker Survey, published last month. 

The survey found that the number of MSEs defaulting was up from 42.8% in October 2022.

The proportion of MSEs offering credit to their customers had declined from 68.5% to 61.1% in the same period. In addition, the number of MSEs receiving trade credit had also declined by 6.1% to 30.6 percent. All three indicators point to harsh economic times.

Micro and small businesses range in size from a single owner-operator to 9 employees.  They borrow from financial inclusion funds (Hustler for example), mobile banking, chamas or groups, mobile till business overdraft, as well as from banks and micro finance institutions.  They borrow to re-stock (59%), and to cover household expenses (44.8%). 

A new need emerged in the June 2023 data that was not there in October 2022 – education, with 23% of the MSEs reporting they are borrowing for this purpose. MSE are also borrowing for business expansion (15.5%) and to cover general business expenses (14%).  Moreover, the top five reasons for borrowing remain the same, regardless of size of the business and gender of the owner.

There had been some controversy about a year ago, arising from a misunderstanding of how credit scores are generated and used. Some policy makers erroneously believed that Credit Reference Bureaus (CRBs) were a hindrance to credit. 

While it was factual that some lenders were using the credit scores as a binary yes or no input into their credit decisions, the Central Bank quickly stepped in to enforce risk-based pricing. 

As our debate progressed it became clear that some misperceptions persist, with some confusion between credit referencing, scoring, and rating.  Roughly speaking credit referencing generates credit scores for individuals.

Credit bureaus and banks use a similar approach to generate MSE credit scores, while credit rating is typically applied to corporates, sub-nationals such as cities and counties, as well as sovereigns.

Risk-based pricing is the appropriate use of credit scores. It gives the lender a scientific estimate of the probability of default, the first step in calculating expected loss, which is what they should price in the lending. 

Simply put, all borrowers deserve credit, the difference should be in the interest rate they have to pay, based on their risk.  This is what the Central Bank of Kenya is demanding that Kenyan banks do with risk-based pricing of loans. So far, CBK has approved risk-based pricing models for a majority of the banks.

Back at the debate, one expert informed the nation that the Hustler fund conducts its own credit scoring based on its data because the financial institutions were not doing so. Credit scoring in closed user groups is not entirely unheard of.  However, better results are obtained by having more data points.  Restricting the analysis to the data available within the Hustler fund reduces the predictive value of the credit scores.

Credit scores for individuals are built by observing verifiable behavioral data such as regularity or frequency of payments, timeliness of payments, and so on.  The scores are more predictive, the more complete the 360-degree view of the credit person is formed by using data from various sources, particularly from credit information sharing, utilities, and so on. The individual, as well as the micro or small business, can improve their scores by assisting bureaus in getting more data points.

Although credit rating is related to referencing, it is an entirely different analytical approach. To begin with, credit rating agencies are licensed by the Capital Markets Authority, while the credit reference bureaus are regulated by the Central Bank. 

Credit rating follows an assessment framework using historical financial performance data, strategy or business plan information, and industry comparisons. The assessment also examines the strength of the management team and performs risk analysis.  The results, which reflect a view on the creditworthiness of a company, are expressed in a scale.  Higher ratings are more creditworthy.

Investors and anyone providing credit are well advised to use credit ratings.  In most jurisdictions, regulators use credit ratings to fast-track approvals of issuers and the securities they are issuing.  In Kenya, there are efforts to extend credit rating to small and medium-sized companies by banks and credit rating entities such as the Metropol Credit Rating Agency.

The credit rating of companies, municipalities, cities, and other sub-sovereigns such as states or counties is common in many parts of the world.  But the rating is only now emerging in Kenya.  Five counties and about 200 corporates have been rated. The highest uptake has been in the insurance sector.

Similar to individual credit scores, corporate and country ratings have a big influence on how countries access loans and the pricing of those loans.  Kenya’s rating was recently downgraded by some rating agencies, much to the chagrin of the government.  On the continent, sovereign ratings are dominated by Western rating agencies. This has led to accusations of assessment bias, leading to lower ratings. 

These lower ratings disadvantage African counties when they issue securities internationally.  The UNDP published a report last April showing that African countries are paying as much as US$74 billion in higher interest costs   This has prompted calls by the African Union for an African credit rating agency, either as a market-led initiative or a specialized agency of the union. An internal team within the Africa Peer Review Mechanism has already been producing regular reviews of sovereign credit ratings.

Rating agencies are regulated by the capital markets authorities, while credit reference bureaus are regulated by central banks. Currently, Kenya has three credit reference bureaus and four rating agencies.

@NdirituMuriithi is an economist