Credit Scoring

Alan Greenspan:
President, Federal Reserve Board
May 1996
We should not forget that the basic economic
function of these regulated entities (banks) is to
take risk. If we eliminate risk taking in order to
reduce failure rates to zero, we will, by
definition, have eliminated the purpose of the
banking system.

Types of Lending Risk

Borrower
Customer fails
failstotopay
pay
Losing money
Wrong Strategy

Change in
market
prices

Processing failures and

frauds
Regulatory compliance

The Universal Balancing Act

Profits

Profits

How can I efficiently manage resources while

meeting business and operating constraints?

Losses

How can I create and re-create strategies in a very

dynamic environment?

Unused
Capacity

How can I achieve these benefits with minimal

change to current systems infrastructure?

Attrition

Everyday Questions
Balancing Marketing and Risk
Should I
target this
consumer?

with what
message?

Will the
consumer
hear it?

Should I
approve?

Will the
consumer
apply?

at what
credit level?

Will the
consumer
use it?

How will I
continue to
influence?

Will the consumer

pay as agreed?
attrite too early?
build large balances?
repeat purchase?
buy add-on services?
be profitable?

Everyday Questions
Balancing Marketing and Risk
Net income
How will I
continue to
influence?

Will the consumer

pay as agreed?
attrite too early?
build large balances?
repeat purchase?
buy add-on services?

Costs

VALUE

Portfolio size
# accounts
Receivables
Risk
Yield

be profitable?

Losses
Growth in each

Everyday Questions
Balancing Marketing and Risk
Should I
target this
consumer?

with what
message?

Will the
consumer
hear it?

Should I
approve?

at what
credit level?

Will the
consumer
apply?

Will the
consumer
use it?

Increase value by improving

decisions
Use BI to optimize multiple
objectives

How will I
continue to
influence?

Will the consumer

pay as agreed?
attrite too early?
build large balances?
repeat purchase?
buy add-on services?
be profitable?

Decision areas
Solicitations
New applications
Account management

Credit line
Authorization
Collections
Reissue

Cross-sell
Keep / sell

Business Objectives

Increase consistency of lending decisions

Consistent & unbiased treatment of applicant
Customers with the same details get the same treatment

Total management control over credit approval systems

Allows for loosening or tightening of lending through credit cycles
Potential increase in approvals

Reduce operating costs

Increase in automated processing

Improve customer service

Fast and consistent decisions at application point

More appropriate limit and authorisation decisions
Reduction in collection actions on low risk accounts
Risk based allocation of credit limits and issue terms

10/18/2013

Business Objectives

Improved portfolio management

Manage credit portfolios more effectively and
dynamically

Better prediction of credit losses

Management ability to react to changes fast & accurately
Ability to measure & forecast impact of policy decisions
Quick and uniform policy implementation

Improved Information
Permits information gathering to assist business needs and
marketing activities
Information gathered can be fed back into future scoring
systems developments, collection activities and strategy
optimization
10/18/2013

10

The BI Solution: Scoring Models

DATA

MODEL

OUTCOME

BI in the Consumer Credit Industry

Numerous quantitative advances have emerged in the
consumer credit risk area to support business strategy
throughout the customer life cycle - beyond simple
credit scores.
At credit origination, analytical models are used to:

Identify likely consumers who are likely to be profitable

Predict propensity to respond to a credit offering
Align consumer preferences with products
Assess borrower credit worthiness
Determine line/loan authorization
Apply risk-based pricing
Evaluate relationship value of the customer

BI in the Consumer Credit Industry

Throughout loan servicing, analytical methods are used to:

Anticipate consumer behaviour (risk) or payment patterns

Determine opportunities for cross-selling
Assess prepayment risk
Identify any fraudulent transactions
Optimize customer relationship management
Prioritize the collections effort to maximize recoveries in the event
of delinquency

Analytical models are fast becoming the back-bone of

efficient consumer credit risk management.
Consumer lending represents an analytically robust and
data-rich environment for credit risk and capital
measurement.

Account Life-cycle Scoring Progression

ACCOUNT STATUS
ON TIME

DELINQUENT

LATE-STAGE
COLLECTIONS

Behavior score
Custom collection score
FICO score

RECOVERY
Bureau-based
recovery score
Custom recovery
score

Other bureau scores or

custom scores
Transaction score

TRIAD adaptive
control system
Primary Decision:
Reduce Loss

Debt Manager-RMS

Secondary Decision:
Risk-Related

Specialty Risk
Assessment

RMS, BridgeLink
Removing Credit:
Additional Precision

Risk Analytics in Consumer Lending

Credit risk in consumer banking has been (traditionally)

driven by 3 Cs of lending (based on judgment):
1.Character willingness to re-pay debt
2.Collateral incentive to re-pay debt
3.Capacity ability to re-pay debt

The presence of a large number of consumers makes this

environment ideal for empirical modeling to predict
borrower behaviour as the basis for acquisition and
management of customers.
Markets with robust credit bureaus further provide the
impetus to use models to predict borrower behaviour.
Credit scores can summarize the details of credit report
and application data into a single actionable metric.

Basic Concept of Credit Scoring

A statistical means of providing a quantifiable risk factor for a
given customer or applicant.
Credit scoring is a process whereby information provided is
converted into numbers that are added together (hence it is an
example of Generalized Additive Models) to arrive at a score
(using a Scorecard).
The objective is to forecast future performance from past
behaviour.
Credit scoring developed by Fair & Isaac in early 1960s
Widespread acceptance in the US in early 80s and UK
early 90s
FICO scores make 75% of US Mortgage loan decisions
Behavioural scoring, introduced later, has been accepted as
more predictive than application scoring

National (US) Distribution of

FICO Scores
30%

28%

% of Population

25%

19%

20%
16%
15%
12%
10%

11%

8%
5%

5%
1%
0%
Up to 499

500-549

550-599

600-649

650-699

FICO Score Range

700-749

750-799

800+

Bad Rates of Major FICO Score

Ranges

Score Range

Bad %

300-500
500-599
600-699
700-850

48%
30%
11%
1.50%

Evaluating the credit applicants: Judgment

Versus Scoring
CHARACTERISTICS

Time at present address

Time at present job
Residential status
Debt ratio
Bank reference
Age
Income

# of Recent inquiries
% of Balance to avail. lines
# of Major derogs.
Overall
Decision
Odds of repayment

JUDGMENT

CREDIT SCORING

+
+
+
+
N/A
-

12
20
5
21
28
15
5

+
+
+

-7
10
35
212

Accept
?

Accept
46:1

Risk Scorecard - Example

Own
Rent
15
25
Years at
<.5
.5-2.49
address
12
10
Prof
Semi-Prf
Occupation
50
44
<.5
.5-1.49
Years on job
2
8
Dept St /
None
Dept-St
Major CC
0
11
Bank
Chq A/c Sav A/c
reference
5
10
<15
15-25
Debt ratio
22
15
No. of recent
0
1
inquiries
3
11
<.5
1-2
Years in file
0
5
# of Loan
0
1-2
Accounts
5
12
% Credit line 0-15%
16-30%
utilization
15
5
Worst
No Rcrd Maj. Def.
reference
0
-59

Residence

Other
NI
10
17
2.5-6.49 6.5-10.49 >10.49
15
19
23
Mgr
Offc.
Bl.Col
31
28
25
1.5-2.49 2.5-5.49 5.5-12.49
19
25
30
Maj-CC
Both
Several
16
27
30
Chq&Sav Other
NI
20
11
9
26-35
36-49
50+
12
5
0
2
3
4
3
-7
-7
3-4
5-7
8+
15
30
40
3-5
6+
8
-4
31-40% 41-50%
>50%
-3
-10
-18
Unsatisf 1 Satisf 2 Satisf
-14
17
24

NI
14
Retired
31
>= 12.5
39
NI
12

NI
13
5-9
-20

3 Satisf
29

Other
22
Retired
43

No Rcrd
0

NI
27
NI
20

Sources of information
CREDIT BUREAU
REPORTS
CREDIT
APPLICATION

Credit reports
Application data
Public records
Prior experience
Demographics
Billing file
Deal terms

Application Scoring

Application scoring is a statistical means of

assessing risk at the point of application for credit
The application is scored once

Application scoring is used for:

Credit risk determination
Loan / Credit card application approval
Loan amount / Credit limit setting

Credit
Decision

Behavioural Scoring

Behavioural scoring is a statistical means of

assessing risk for existing customers through
internal behavioural data
Customers/accounts scored repeatedly

Behaviour scoring is used for:

Authorisations
Limit increase/overdraft applications
Renewals/reviews
Collection strategies
Debit
$1344. 12
Debit
$1344.
Debit
$234.
01 12
Debit
$1344.
Debit $987.56
$234. 01 12
Debit
Debit $987.56
$234. 01
Debit
Debit
$6543.22
Debit $6543.22
$987.56
Debit
Debit
$32423.11
Debit
$6543.22
Debit $2556.00
$32423.11
Total
Debit $2556.00
$32423.11
Total
Total

$2556.00

Risk
Grading

The Objective

The objective of a scorecard is to use characteristics that

discriminate between Good and Bad accounts with sufficiently
high accuracy.
The score is a measure of the probability of being a Good or
Bad performer.
If the scorecard is a good one then the mean score of Bads is
lower than the mean score of the Goods.

Good/Bad Odds (probability)

A scoring system does not individually identify a good

performer from a bad performer, it classifies an
applicant in a particular Good/Bad odds group.
An applicant belonging to a 200 to 1 group, appears
pretty safe and profitable.
If the applicant belongs to a 4 to 1 risk group, we would
no doubt find the risk unacceptable.
There is a cut-off point where it is not profitable for
the bank to accept a certain Good to Bad ratio
Based on the above, it is accepted that there will be
some bads above the cut-off level set, and some
goods below the cut-off level set.

Credit score = odds (risk)

SCORE

ODDS

220

64 / 1

180

16 / 1

4/1

1/1

140

100

Scores are Calibrated (Aligned) to Odds

(on a Log Scale)

1
0

Ln(Odds)

-1
Actual Data

-2

Std Line

-3
-4
-5
505

515

525

535

545

555

565

575

585

595

Score

For any given score the probability of Bad can be found

using the equation of the Log-odds (straight) line.

How Is a Credit Scoring Model

Developed ?
Analysis of a large set of consumers (>= 1
Million)
Identification of common variables that
define behavior
Statistical models are then built that assign
weights to each variable
Adding all variables combines to make an
individual score

Scorecard Construction
Data Gathering
Population Identification
Data Availability
Data Extraction
Sampling

Statistical Analysis
Characteristic Analysis
Characteristic Selection
Multivariate model build
Reject Inference

Outsourced
External Data Source
Scorecard Vendor

Generic Scorecard
Validation
Set cut-off Score
Implementation

Customised Scorecard
Scorecard Monitoring