What is merchant underwriting?
Before a financial services company will permit a business to use its payment processing capabilities, it needs to complete some level of risk assessment and due diligence.
Put differently, the bank wants to know that the merchant is a legitimate business and financially sound. It needs to ensure it doesn’t face outsized risk from allowing the merchant to process payments through its infrastructure.
This process is formally referred to as merchant underwriting, where a financial institution will complete a formal risk evaluation of a new customer.
During this process, the merchant will supply financial documents and other required forms for the financial institution to review and assess their risk profile, which determines:
- Whether the merchant can open up an account
- Payment processing limits
- Cash reserve requirements
If the bank determines that the merchant presents a low enough financial risk, they can proceed with the account opening.
The merchant underwriting process explained
When a company wants to start accepting credit card payments, the provider first completes the underwriting process, which typically involves the following steps:
Step 1: Submit an application
The process begins when a merchant submits an application form to the bank or financial institution.
The exact requirements of the application can vary between organizations, though a merchant can typically expect to provide:
- Several months' worth of bank statements
- Most recent financial statements (profit and loss statements, balance sheet, etc.)
- Relevant reports from previous payment processors to showcase chargeback rates, disputes, etc. (for existing companies)
Step 2: The bank completes the risk assessment
After completing the application, the financial institution will review the submitted documents to evaluate the merchant’s risk profile.
Using their internal risk assessment models, the underwriting team will take a look at the company’s financial information, credit history, chargeback trends, and other operational considerations to determine the overall riskiness of doing business with the merchant.
Again, the goal for the institution is to make sure it’s not taking on outsized risk by allowing the merchant to process payments on its network.
Step 3: The applicant undergoes a compliance review
Beyond any internal standards the financial institution considers during the underwriting process, it will also need to meet industry compliance requirements.
This primarily includes Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements, which help further verify that a business is trustworthy and generates income through legitimate operations.
These checks are typically completed with documents and information provided during the application process, including:
- Employer identification number (EIN)
- Formation documents
- Operating agreements
- Business licenses
Step 4: The merchant account is approved or denied
Based on the risk assessment and compliance checks, the payment processor will either deny or approve the merchant’s application for an account.
It is possible that the financial institution requires additional follow-up information from the merchant before making its decision, depending on what the initial assessment returned.
Either way, the bank’s final decision may come with additional conditions or considerations, based on the merchant’s risk profile. For instance, the bank may impose higher payment processing fees on a merchant it deems as “higher risk” to make up for it.
Factors influencing merchant underwriting decisions
Payment processors aren’t just focused on one or two key points during underwriting. Instead, they rely on a number of different factors to get the full picture about the merchant’s financial stability and legitimacy.
Financial health and creditworthiness
The basis for merchant underwriting is the company’s financial and credit history.
Namely, the payment processor uses the business’s credit score to determine its reliability and track record for making debt repayments.
Additionally, the company’s historic balance sheet, cash flow statement, and income statement help the underwriters assess the company’s long-term solvency.
The applicant’s financials and credit score could completely disqualify them from a merchant account. If approved, this information can be used to determine the exact terms and conditions the provider imposes, including fees or reserve requirements.
Business model
The company’s financials are important in the underwriting process. However, the team will also consider the overall strength of the industry and the business model they use.
For example, a company that operates in a new or high-risk industry, like gambling or cannabis, may face additional scrutiny given the inherent risk of the business model and its legality. This is true even if the individual company has a good credit score and financial standing.
Transaction history and processing volume
Underwriters will also want to see the typical transaction volume that the company processes, including chargeback history and refund requests.
This helps them understand overall trends and stability in incoming payments. Plus, it gives the financial institution a clear way to assess the merchant’s payment processing needs, the business’s reputation with its customers, and possible fraud risk.
Risk management strategy
Depending on the financial institution, the team may also be interested in operational factors, such as any risk management practices the merchant has employed to address payment fraud, chargebacks, and refunds.
Risk management systems can help a company’s approval odds, especially if they already operate in a risky industry, have a limited credit history, or have other factors that could impact their application.
Challenges in merchant underwriting
Applying for a merchant account isn’t always a straightforward process. Here are some of the challenges that businesses can encounter during underwriting:
Lengthy approval process
From start to finish, the underwriting process can take up to a few weeks to complete.
This includes the time the company spends compiling the required documentation and submitting the application, to allowing the financial institution time to complete their risk assessment and due diligence.
While necessary for the bank to meet compliance requirements and internal risk management standards, this also means that it can take a while for a company to open up a new merchant account and start processing payments.
This lengthy approval process can lead to operational disruptions for businesses that want to accept payments and continue with business as usual, even when opening up a new merchant account.
Credit requirements
Underwriting can be challenging for newer merchants who have low or no credit history.
A company with a low credit score may have a hard time finding a provider to work with them, given their history of late payments and other financial challenges.
Likewise, the lack of transaction history for a new merchant makes it challenging for financial institutions to assess a company's trustworthiness and reliability, which can result in rejection.
Higher fees and/or restrictions for higher-risk accounts
On a similar note, merchants that a payment processor considers “higher risk” may be able to open up an account, but with certain restrictions or conditions imposed.
For example, if a new merchant applies for an account with no credit history, the bank or financial institution may approve them for an account, but with higher cash reserve requirements.
The role of automation in merchant underwriting
Given the many moving parts of merchant underwriting, the process is ripe for overhaul with the help of advanced technologies.
In particular, more teams are adopting automation to help streamline various aspects of the process, including document intake and processing, risk assessment, and KYC checks.
With automated tools, underwriting teams can complete each step of the process more quickly and with fewer errors than when done manually.
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