A Psychology-Enabled Solution to Small- and Medium-Sized Enterprise Finance

Abstract

Industrial and Organizational Psychology has developed tools to solve a similar problem: personnel selection. Big companies need to select among a large number of individuals applying for a job. This has to be done with relatively low transaction costs, and there is little information available to separate the good candidates from the bad candidates—a very similar problem to that facing the banks. Psychologists have developed psychometric tools to measure things like personality, motivation, outlook, and intelligence, which are related to subsequent job performance. These tools have been shown to work even better than other methods like interviews and background checks, and are widely used. What if they could be applied to the selection of small businesses to lend to? We review a variety of academic studies that have already used these tools to evaluate entrepreneurs and distinguish entrepreneurs from non-entrepreneurs and good entrepreneurs from bad entrepreneurs. The studies center on three main themes: personality, intelligence, and honesty. The first two relate to the ability to repay a loan, in that they could identify entrepreneurs who are more likely to successfully grow their business and its cash flows. Honesty relates to the willingness to repay a loan, as banks need to worry not just if the entrepreneur has enough money to repay but if they then decide to repay or else take the money and run. These studies provide initial insight into what particular characteristics and abilities could be systematically related to credit risk, and used for future lending to small business owners who would traditionally be rejected by banks due to a lack of information.