Settling the score: A psychometric assessment that unlocks credit to entrepreneurs in the Muslim world

$438,000 | Egypt | Stage 2

The problem: The missing middle 

Developing countries face a “missing middle” gap: typically, their economies comprise many tiny microenterprises and several large firms, but strangely few Small and Medium Enterprises (SMEs), compared to developed economies.  The “missing middle” phenomenon persists because finance is not reaching entrepreneurs in this critical market segment. 

Lenders are aware of the SME segment and its profit potential.  What they lack are affordable, appropriate tools to screen applicants and identify high potential entrepreneurs.  Traditional corporate risk-scoring models use formal financial statements, collateral, and past borrowing history—indicators that aren’t available for most SMEs. The exclusion of SMEs from these screening and financing models is especially pronounced in the Muslim world, where many entrepreneurs do not seek traditional debt contracts since they are not Shariah-compliant. In Pakistan alone, there are an estimated 2.4 million “missing” SMEs. 

The solution: A new way of assessing credit risk 

EFL

Unlocking entrepreneurial potential in developing countries requires a new approach to screening and risk evaluation.  Harvard Kennedy School professor Asim Khwaja helped launch the Entrepreneurial Finance Lab Research Initiative (EFL-RI) at the Center for International Development to evaluate low-cost, innovative solutions to this screening problem.  The approach uses psychometric assessment as a scalable, automated screening tool of entrepreneurial success and credit risk.  Questions about an entrepreneurs’ intelligence, business acumen, honesty and psychological profile—can directly predict their ability and willingness to repay loans. These tools can be automated, do not require a credit history, and are resistant to manipulation.  When combined with the right financial contracts, they could represent a breakthrough in profitable lending to the missing middle. 

In tests over the last four years in 7 countries across Latin America and Africa, the tool was able to predict default as well as or better than credit scoring models used in developed countries with corporate clients.. As a result, tens of thousands of entrepreneurs across dozens of countries and languages have used the application, from one-person microenterprises borrowing $800 to medium-sized enterprises receiving financing of over $500,000. 

With Stage 2 support of $438,000 from DIV, EFLRI will extend these tools to the Muslim region, particularly focusing on the Middle East and Asia. EFLRI will adapt the assessment to the local context, and then partner with a financial institution in the region to implement the tool on a sample of SME clients. The resulting data will be used to develop the scoring tool further to the differing business and cultural context including the islamic shariah aspects, and evaluate its predictive power and scalability potential. The results of the pilot will be presented to financial institutions across the region to encourage their own piloting of the SME lending tool.  

Potential cost effectiveness, impacts, and implications

In an effort to provide commercially viable and scalable solutions, in 2010 EFLRI researchers helped create an independent, private organization, EFL Global Limited, that has developed and rapidly scaled-up tools to identify high-potential entrepreneurs and perform credit scoring.  EFL Global has partnered with some of the leading banks in Africa and Latin America, including Standard Bank of South Africa and BBVA Bancomer of Mexico.  

The low transaction cost and highly scalable nature of psychometric-based credit scoring enables rapid global adoption and therefore creates a significant social impact. If the distortion in the firm size distribution in developing countries was removed and the distribution regularized, thus “filling” the missing middle, estimates suggest that the GDP across developing countries would increase by over $3.6 trillion dollars annually. This shift could create millions of new SMEs. In Africa, the initial research and adaptation of the tool has already started to catalyze private-sector scale-up. Financial institutions on the continent are now lending out over $1.5 million dollars per week based on these tools, to small-scale entrepreneurs that would have previously been rejected. Thus, while the challenges and issues do vary, there is great potential for scaling up the tool in the Muslim world as well. 

Learn more

• Check out the EFL-RI website for the latest news and updates

• Meet Dr. Asim Khwaja, Priniciple Investigator for EFL-RI

• Watch this CNBC video about EFL Global Limited, the independent and private organization that EFLRI researchers helped to create