Credit rating of small business Affiliation This paper evaluates whether a bank should or should not grant a loanto a small business based on the credit rating. Specifically, it assesses if the bank should grant the loan to the small business if it has a bad credit rating. Evidence has been derived from peer reviewed scholarly articles in order to support the justifications. Profits are fundamental to any bank setting. Therefore, when a bank is evaluating whether to grant a loan or not, it assesses the risk associated with granting that loan. According to Stein (2004), banks frequently ask for a certain regulation for identifying a cut-off over which the loan will be given and below which it will not (Stein, 2005).

Introduction

Small businesses play an important role in the economy of many countries. More importantly, many of them rely on banks to finance their businesses. Granting of loans to small businesses is an intricate matter that requires the bank to gather information that helps it to assess the businesses’ ability to pay back the loan and not default (Frame & White, 2004). Hence, banks are resulting to using credit rating scores to determine if or if not to grant a loan to the business. The question is if bad credit rating means a bank should not grant a loan to a small business owner to expand or invest in his business? Why and why not?

According to Petrovic and Davidovic (2011), loan granting to small businesses poses a test to banks. However, banks should give loans to small businesses based on their credit rating. It has been found that small businesses having in-between credit ratings are likely to rely on loans from banks. Conversely, for small businesses that have low ratings, evaluation fails to avail reason to grant loans as they are thought to have nothing to lose if they default (Petrovic & Davidovic, 2011). The credit rating of a small business borrower functions to envisage future acts that the borrower will without evaluation. Hence, a bad credit rating will imply that the bank should not grant a loan to the business as the credit rating serves to predict the actions of the business after getting the loan. The credit rating obtained aids in the formation of the bank’s decision (Diamond, 1991).

On the other hand, bad credit rating should not be used to deny a small business a loan grant because banks do not have all the information concerning the borrower. Even if the bank obtains a good credit rating concerning the borrower that allows a bank to grant the small business a loan, the borrower may opt to default even if the business does well. A scenario termed as moral hazard. The bank’s loan policy may also be a factor in determining the type of borrowers the bank gets. The rate of interest banks charge on loans may draw low-quality borrowers, in which case the credit rating will be low (Inter-American Development Bank, 2004).

References

Diamond, D. W. (1991). Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt. Journal of Political Economy, 99, 689-721.

Frame, W. S., & White, L. J. (2004). Emprical studies of financial innovation: lots of talk, little of action? Journal of Economic Literature, 116-144.

Inter-American Develpment Bank. (2004). Unlocking Credit: The Quest for Deep and Stable Bank Lending. Washington DC: IDB.

Petrovic, R., & Davidovic, M. (2011). Granting Loans To Legal Entities As The Banks Business Process. International Journal of Industrial Engineering Mnagement, 2(2), 69-76.

Stein, R. M. (2005). The relationship between default prediction and lending profits: Integrating ROC analysis and loan pricing. Journal of Banking & Finance, 29, 1213-1236.