Apr 30, 2013

Providing Credit to Latin America’s “Missing Middle”

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There are approximately 34 million businesses in Latin America and the Caribbean, most of them small, informal, and with limited access to credit. Since they are unable to provide collateral, a reliable financial history, or accounting information, these businesses cannot meet the financial information requirements of commercial banks to obtain loans to improve and expand their operations.

The result is that they are stuck in a vicious cycle of underdevelopment, which in turn undermines economic growth and job creation.

To try to reverse this situation, the IDB in 2012 approved a pioneering facility to support adoption of an alternative credit scoring methodology that could be a game-changer for these businesses, often referred to as the region’s “missing middle.” The methodology, which is called psychometric testing, is a tool that has been successfully used by human resources departments for pre-employment screening for several years. More recently it has been adapted to help financial intermediaries assess the creditworthiness of potential borrowers.

Developed by Harvard’s Entrepreneurial Finance Lab Research Initiative, psychometric testingfor credit assessment is automated, costs little, and has already been implemented by financial institutions in 11 countries in Africa and two in Latin America. Potential borrowers have to answer a list of 150 questions measuring their intelligence, business skills, personality, ethics, character, and beliefs. This information generates a score that allows financial institutions to assess the potential borrowers’ willingness to pay back a loan.

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Results from pilot projects of psychometric testing compared the scores of tested entrepreneurs and their actual business performance and repayment history. It found that the test is good predictor of creditworthiness and a cost-effective way for financial intermediaries to reduce the costs of their credit assessment operations.

Simulated implementation of the testing by banks suggests a 20 to 45 percent reduction in defaults and a 15 to 30 percent increase in profits, with operational costs of the lending process at less than 40 percent of the cost of traditional evaluation and due diligence. Overall, the test exceeded the predictive power of traditional credit-scoring models in developing countries.

The IDB facility will allow as many as eight financial institutions to pilot psychometric testing in the region. Results from the initiative will help the region close its estimated financing gap of between $330 billion to $410 billion for small and medium-sized companies—a game-changer for businesses that could be a major resource for growth in Latin America and the Caribbean.