Imagine you are a bank.  What information would you need to determine the creditworthiness of an entrepreneur or a small business?  If the business is at an early stage, financial statements may not be very valuable.  If the business has little physical capital to be used as collateral, it might be too risky.  If the entrepreneur has no credit history, it might be game over.  Microfinance gets around this with the group-lending model, because while it is costly for a lender to assess the creditworthiness of an entrepreneur with no collateral, others in her social network can.  Furthermore the lending group's assessment is credible because its members have something to lose if the entrepreneur defaults on her loan.  Microfinance as well as banks, however, do not reach many small and medium enterprises in developing countries.

The work at the Entrepreneurial Finance Lab (EFL) at Harvard's Center for International Development has devised an innovative approach to reaching this segment.  Outlined in a recent Business Week article, EFL has been researching the use of a psychometric test to evaluate the creditworthiness of entrepreneurs.  It asks questions such as "Do you enjoy going to parties?" to assess business skills, integrity, intelligence, and motivation.  Three years of pilots in Kenya, South Africa, Rwanda, Colombia, and Peru have shown that banks using the test can realize equivalent or better results than traditional credit assessment models.  Some banks saw default rates drop from 40% to 25%.  From here the EFL will roll out a even bigger test in Kenya and South Africa in August, with the largest bank on the African Continent, Standard Bank of South Africa.

Some are skeptical that researchers from Harvard can determine the creditworthiness of entrepreneurs in developing countries.  It isn't the researchers who are making the decisions but algorithms based on the data the test gathers that determines it.  At it's core the approach is implying that this sort of algorithm using data glean directly from entrepreneurs may be better at determining creditworthiness than humans collecting and processing information themselves (see point number one of "what turns me on lately" below).  The bottom line is that the banking system as currently structured isn't reaching many entrepreneurs in developing countries.  By relying instead on a radically different set of information and process to make lending decisions, we can potentially bring credit to entrepreneurs who currently do not have access.  I haven't seen the study in detail but considering who's driving the work, I doubt it would be easy to poke holes in the evidence.  

This effort happens to be led by Asim Khwaja, one of my favorite professors from Harvard.  He is not just a brilliant analytical mind who has studied firms and financial markets in developing countries extensively, but he is also an out of the box thinker.  So while this may sound like a crazy idea relative to the status quo, it's actually an innovation on par with microfinance. 

If this works, it has the potential to be revolutionary.  All of us concerned about access to finance in developing countries should most certainly stay tuned.