01 Dec 2015
Truth in Lending
In the absence of financial data, how do you decide who is creditworthy? Just ask.by April WhiteTopics:
What percentage of managers do you think steal from their companies? Your answer to that question can tell a financial institution a lot about your creditworthiness, says DJ DiDonna (MBA 2010), cofounder and chief strategy officer of the for-profit Entrepreneurial Finance Lab. And that may just be the answer to developing a strong small-business sector in emerging markets.
In more developed markets, a bank can make loan decisions based on credit scores, that three-digit distillation of a lifetime of bill payment habits and bank account balances. But in emerging economies, that financial data often doesn’t exist. Without a way to evaluate credit applicants, lenders are not inclined to make the type of small-business loans—for instance, just $5,000 for working capital or $20,000 for machinery—that can help grow economies.
The Entrepreneurial Finance Lab’s 20- to 30-minute credit test is based on research in psychometrics conducted at Harvard’s Center for International Development to help lenders understand both the skills and the personality of loan applicants. The questions on the test seek not to mimic the data collection behind a conventional credit score but instead to do the more sophisticated due diligence of a venture capital deal. “It’s asking a lot of the same questions that you would try to tease out in a conversation with someone. Are they reliable? Are they confident? Are they optimistic?” says DiDonna.
The test questions, completed on a tablet, phone, or computer, with or without Internet access, are designed to elicit the most honest response possible. To do that, DiDonna explains, you don’t ask an applicant, “Have you ever told a lie?” Instead, you ask a question designed to reveal how a person views the world—for example, someone who thinks a high percentage of managers steal from their companies is more likely to do so himself—and you ask the same question in a variety of ways. The Entrepreneurial Finance Lab also collects a second level of data on the applicants: How do they fill out the application? How long does it take them to answer each question? Do they change their answers? (Men are more likely than women to change their number of dependents or marital status, DiDonna has observed.)
In the last five years, the Entrepreneurial Finance Lab has administered 275,000 tests, which have been the basis for approximately $500 million in lending in developing countries such as Kenya, India, Indonesia, and Peru.
In all this data, patterns emerge, sometimes challenging a loan officer’s gut instincts: “The typical idea of what makes a great entrepreneur is often a little bit off,” DiDonna says. You don’t always want a risk taker; you want someone who can identify and mitigate risk. You don’t always want someone who is optimistic. “If you’re optimistic and 17, that’s very different than if you’re 40 and optimistic with experience,” he says. “You can fight those typical biases because you are using a data-based approach.”
As the Entrepreneurial Finance Lab continues to expand its global reach, now with more than 50 employees on four continents, the company’s model has become increasingly sophisticated at identifying cultural nuances. “But about two-thirds of the model’s predictive power is consistent across different cultures,” says DiDonna. In other words, many of the things that make an entrepreneur successful are constant from Boston to Nairobi and from Bogotá to Jakarta.
Class of MBA 2010, Section E