Small Business Credit Scoring and Its Pitfalls: Evidence from Japan

This paper studies the Japanese credit scoring market using data on 2,000 small and medium‐sized enterprises and a small business credit scoring (SBCS) model widely used in the market. After constructing a model for determining a bank's profit maximization, some simulation exercises are conducted, and pitfalls of lending based on SBCS are indicated. The simulation results suggest that the reason why SBCS loan losses occur would be the combination of adverse selection and window‐dressing problems. In addition, omitted variable bias and transparency of financial statements are important.