Underwriting Small Business Merchants: Seeing Risk More Accurately

According to a recent study, difficult economic times can spur greater entrepreneurship. The study, conducted by the Ewing Marion Kauffman Foundation, found that a majority of the largest, most successful companies in the world were founded during a recession or bear market. The study suggests that, paradoxically, recessions often provide entrepreneurs with the right market conditions to start their business. In a distressed economy, competitive barriers are lower and talented employees are available due to higher unemployment rates.

After suffering one of the worst economic recessions in history, we are seeing lots of small businesses start to appear. This is an encouraging trend for the economy, but it presents a challenge to the organizations servicing these small businesses. Merchant acquirers are enabling these new businesses to accept credit cards, debit cards, and other alternative payment products in their day-to-day operations. By doing so, these acquirers are taking on a high level of risk. If one of their merchants accepts payments for a product that they fail to deliver, the resulting chargebacks can often end up as losses on the acquirer’s books. In order to prevent this, merchant acquirers need to be able to assess exactly how risky each new merchant that they are underwriting is going to be.

The challenge facing merchant acquirers is to accurately assess merchant risk in an environment in which traditional credit risk data and analytic products have become less reliable. Acquirers who are underwriting small businesses need to understand the credit worthiness of the business’ principal. However, due to the recent recession, traditional credit reports and scores have become a lot less predictive. A consumer who went upside down on their mortgage three years ago (during the height of the recession), might have gotten back on their feet since then. A consumer, who lost his job and missed a few credit card payments when unemployment was at 10%, might have stabilized as the economy has improved. These are exactly the type of consumers that, due to changes wrought by the recession, are starting new businesses. Despite their recession-related credit trouble, they might now be in a position to successfully launch and operate a business. The problem is that merchant acquirers looking at these consumers through traditional creditworthiness indicators might not see them as profitable, low risk merchant accounts.

So how do merchant acquirers overcome this challenge? First, merchant acquirers need to look beyond traditional credit data during the underwriting process. There are a number of alternative data sources that can supplement traditional sources to provide a much more accurate, post-recession view of consumers’ creditworthiness. We’ve seen alternative data products that can increase the number of approved accounts by 15% without changing the acquirer’s risk tolerance.

Once merchant acquirers have incorporated alternative data for a more accurate automated risk assessment, they need to intelligently apply their manual underwriting resources to the applications that are on the fence. There are always going to be a few merchants that fall right on the cut-off line. They might have a questionable credit history. There might be a fraud concern. There might not be enough data available for an automated decision. These are the merchant applications that you want your underwriters working on. You want them to conduct thorough research on the merchant in order to understand the risk that they pose. Ultimately, your underwriters need to determine if the merchant is going to be able to follow their business plan and deliver their products on-time and undamaged. By automating the merchant risk assessment process, acquirers can efficiently process the majority of their applications and leave only the most questionable cases for their underwriters to deal with.

Merchant acquisition is a challenging process. This rising tide of post-recession entrepreneurship represents a great opportunity for merchant acquirers. However, acquirers cannot afford to underwrite more risk than they can handle. In order to successfully seize today’s small business merchant opportunity, acquirers need to invest in an underwriting system that can accurately and efficiently sort the good merchant risks from the bad.