Intelligent Credit Scoring E-Book

Naeem Siddiqi

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: SAS Institute Inc
• Sprache: Englisch

Seitenzahl: 654

Veröffentlichungsjahr: 2016

Beschreibung

A better development and implementation framework for credit risk scorecards Intelligent Credit Scoring presents a business-oriented process for the development and implementation of risk prediction scorecards. The credit scorecard is a powerful tool for measuring the risk of individual borrowers, gauging overall risk exposure and developing analytically driven, risk-adjusted strategies for existing customers. In the past 10 years, hundreds of banks worldwide have brought the process of developing credit scoring models in-house, while 'credit scores' have become a frequent topic of conversation in many countries where bureau scores are used broadly. In the United States, the 'FICO' and 'Vantage' scores continue to be discussed by borrowers hoping to get a better deal from the banks. While knowledge of the statistical processes around building credit scorecards is common, the business context and intelligence that allows you to build better, more robust, and ultimately more intelligent, scorecards is not. As the follow-up to Credit Risk Scorecards, this updated second edition includes new detailed examples, new real-world stories, new diagrams, deeper discussion on topics including WOE curves, the latest trends that expand scorecard functionality and new in-depth analyses in every chapter. Expanded coverage includes new chapters on defining infrastructure for in-house credit scoring, validation, governance, and Big Data. Black box scorecard development by isolated teams has resulted in statistically valid, but operationally unacceptable models at times. This book shows you how various personas in a financial institution can work together to create more intelligent scorecards, to avoid disasters, and facilitate better decision making. Key items discussed include: * Following a clear step by step framework for development, implementation, and beyond * Lots of real life tips and hints on how to detect and fix data issues * How to realise bigger ROI from credit scoring using internal resources * Explore new trends and advances to get more out of the scorecard Credit scoring is now a very common tool used by banks, Telcos, and others around the world for loan origination, decisioning, credit limit management, collections management, cross selling, and many other decisions. Intelligent Credit Scoring helps you organise resources, streamline processes, and build more intelligent scorecards that will help achieve better results.

Leseprobe

More Praise for Intelligent Credit Scoring

Once again, Naeem gives us a detailed and insightful book for risk managers and non-risk managers alike on the importance of credit risk scorecards as a core competency for powerful business decisions.

—Ricardo Plaisant, Consumer Chief Risk Officer, Citi-Banamex

The most comprehensive, simple, and practical reference for risk professionals dealing with credit risk scorecards. It encompasses in detail the entire credit risk scorecard lifecycle right from scorecard development and validation to implementation and monitoring. In addition to quantitative techniques, Intelligent Credit Scoring also covers the practical aspects of credit scoring critical for business users.

—Faizan Iqbal Saleh, Director and Head, Risk Strategy–Risk Analytics, Al Rajhi Bank

Naeem's book has been a highly valuable resource for BNI in developing in-house scoring capabilities since 2012 by providing us with solid reference and insight about the scorecard development and implementation process. His approach is simple and easy to understand. This new book will surely be another comprehensive reference for scorecard developers.

—Harri Suhendra, Head of Scoring and Modeling, Bank Negara Indonesia

Once again, Mr. Naeem Siddiqi, the guru of credit scoring, has come out with a book that is easy to understand and gives in-depth information on credit scoring model development methodologies, that will be helpful for all levels of participants who want to develop a predictable and usable credit scoring model.

—Khairul Perera, Chief Credit Officer, Bank Islam Malaysia Berhad

Wiley & SAS Business Series

The Wiley & SAS Business Series presents books that help senior-level managers with their critical management decisions.

Titles in the Wiley & SAS Business Series include:

Analytics in a Big Data World: The Essential Guide to Data Science and Its Applicationsby Bart Baesens

Bank Fraud: Using Technology to Combat Losses by Revathi Subramanian

Big Data Analytics: Turning Big Data into Big Money by Frank Ohlhorst

Big Data, Big Innovation: Enabling Competitive Differentiation through Business Analytics by Evan Stubbs

Business Analytics for Customer Intelligence by Gert Laursen

Business Intelligence Applied: Implementing an Effective Information and Communications Technology Infrastructure by Michael Gendron

Business Intelligence and the Cloud: Strategic Implementation Guide by Michael S. Gendron

Business Transformation: A Roadmap for Maximizing Organizational Insights by Aiman Zeid

Connecting Organizational Silos: Taking Knowledge Flow Management to the Next Level with Social Media by Frank Leistner

Data-Driven Healthcare: How Analytics and BI Are Transforming the Industry by Laura Madsen

Delivering Business Analytics: Practical Guidelines for Best Practice by Evan Stubbs

Demand-Driven Forecasting: A Structured Approach to Forecasting, Second Edition by Charles Chase

Demand-Driven Inventory Optimization and Replenishment: Creating a More Efficient Supply Chain by Robert A. Davis

Developing Human Capital: Using Analytics to Plan and Optimize Your Learning and Development Investments by Gene Pease, Barbara Beresford, and Lew Walker

The Executive's Guide to Enterprise Social Media Strategy: How Social Networks Are Radically Transforming Your Business by David Thomas and Mike Barlow

Economic and Business Forecasting: Analyzing and Interpreting Econometric Results by John Silvia, Azhar Iqbal, Kaylyn Swankoski, Sarah Watt, and Sam Bullard

Foreign Currency Financial Reporting from Euros to Yen to Yuan: A Guide to Fundamental Concepts and Practical Applications by Robert Rowan

Harness Oil and Gas Big Data with Analytics: Optimize Exploration and Production with Data Driven Models by Keith Holdaway

Health Analytics: Gaining the Insights to Transform Health Care by Jason Burke

Heuristics in Analytics: A Practical Perspective of What Influences Our Analytical World by Carlos Andre Reis Pinheiro and Fiona McNeill

Human Capital Analytics: How to Harness the Potential of Your Organization's Greatest Asset by Gene Pease, Boyce Byerly, and Jac Fitz-enz

Implement, Improve and Expand Your Statewide Longitudinal Data System: Creating a Culture of Data in Education by Jamie McQuiggan and Armistead Sapp

Intelligent Credit Scoring: Building and Implementing Better Credit Risk Scorecards, Second Edition by Naeem Siddiqi

Killer Analytics: Top 20 Metrics Missing from Your Balance Sheet by Mark Brown

Predictive Analytics for Human Resources by Jac Fitz-enz and John Mattox II

Predictive Business Analytics: Forward-Looking Capabilities to Improve Business Performance by Lawrence Maisel and Gary Cokins

Retail Analytics: The Secret Weapon by Emmett Cox

Social Network Analysis in Telecommunications by Carlos Andre Reis Pinheiro

Statistical Thinking: Improving Business Performance, Second Edition by Roger W. Hoerl and Ronald D. Snee

Strategies in Biomedical Data Science: Driving Force for Innovation by Jay Etchings

Style & Statistic: The Art of Retail Analytics by Brittany Bullard

Taming the Big Data Tidal Wave: Finding Opportunities in Huge Data Streams with Advanced Analytics by Bill Franks

Too Big to Ignore: The Business Case for Big Data by Phil Simon

The Analytic Hospitality Executive by Kelly A. McGuire

The Value of Business Analytics: Identifying the Path to Profitability by Evan Stubbs

The Visual Organization: Data Visualization, Big Data, and the Quest for Better Decisions by Phil Simon

Using Big Data Analytics: Turning Big Data into Big Money by Jared Dean

Win with Advanced Business Analytics: Creating Business Value from Your Data by Jean Paul Isson and Jesse Harriott

For more information on any of the above titles, please visit www.wiley.com.

Intelligent Credit Scoring

Building and Implementing Better Credit Risk Scorecards

Second Edition

Naeem Siddiqi

Cover image: background © Candice Cusack/iStockphoto; spreadsheet © Pali Rao/Getty Images, Inc.

Cover design: Wiley

Copyright © 2017 by SAS Institute, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

ISBN 9781119279150 (Hardcover) ISBN 9781119282334 (ePub) ISBN 9781119282297 (ePDF)

For Saleha

CONTENTS

Acknowledgments

Chapter 1: Introduction

Scorecards: General Overview

Notes

Chapter 2: Scorecard Development: The People and the Process

Scorecard Development Roles

Intelligent Scorecard Development

Scorecard Development and Implementation Process: Overview

Notes

Chapter 3: Designing the Infrastructure for Scorecard Development

Data Gathering and Organization

Creation of Modeling Data Sets

Data Mining/Scorecard Development

Validation/Backtesting

Model Implementation

Reporting and Analytics

Note

Chapter 4: Scorecard Development Process, Stage 1: Preliminaries and Planning

Create Business Plan

Create Project Plan

Why “Scorecard” Format?

Notes

Chapter 5: Managing the Risks of In-House Scorecard Development

Human Resource Risk

Technology and Knowledge Stagnation Risk

Chapter 6: Scorecard Development Process, Stage 2: Data Review and Project Parameters

Data Availability and Quality Review

Data Gathering for Definition of Project Parameters

Definition of Project Parameters

Segmentation

Methodology

Review of Implementation Plan

Notes

Chapter 7: Default Definition under Basel

Introduction

Default Event

Prediction Horizon and Default Rate

Validation of Default Rate and Recalibration

Application Scoring and Basel II

Summary

Notes

Chapter 8: Scorecard Development Process, Stage 3: Development Database Creation

Development Sample Specification

Sampling

Development Data Collection and Construction

Adjusting for Prior Probabilities

Notes

Chapter 9: Big Data: Emerging Technology for Today’s Credit Analyst

The Four V’s of Big Data for Credit Scoring

Credit Scoring and the Data Collection Process

Credit Scoring in the Era of Big Data

Ethical Considerations of Credit Scoring in the Era of Big Data

Conclusion

Notes

Chapter 10: Scorecard Development Process, Stage 4: Scorecard Development

Explore Data

Missing Values and Outliers

Correlation

Initial Characteristic Analysis

Preliminary Scorecard

Reject Inference

Final Scorecard Production

Choosing a Scorecard

Validation

Notes

Chapter 11: Scorecard Development Process, Stage 5: Scorecard Management Reports

Gains Table

Characteristic Reports

Chapter 12: Scorecard Development Process, Stage 6: Scorecard Implementation

Pre-implementation Validation

Strategy Development

Notes

Chapter 13: Validating Generic Vendor Scorecards

Introduction

Vendor Management Considerations

Vendor Model Purpose

Model Estimation Methodology

Validation Assessment

Vendor Model Implementation and Deployment

Considerations for Ongoing Monitoring

Ongoing Quality Assurance of the Vendor

Get Involved

Appendix: Key Considerations for Vendor Scorecard Validations

Notes

Chapter 14: Scorecard Development Process, Stage 7: Post-implementation

14.1 Scorecard and Portfolio Monitoring Reports

14.2 Reacting to Changes

14.3 Review

Notes

Appendix A: Common Variables Used in Credit Scoring

Appendix B: End-to-End Example of Scorecard Creation

Bibliography

About the Author

About the Contributing Authors

Index

EULA

List of Tables

Chapter 6

Exhibit 6.5

Exhibit 6.6

Exhibit 6.7

Exhibit 6.9

Exhibit 6.10

Exhibit 6.11

Exhibit 6.15

Exhibit 6.16

Chapter 8

Exhibit 8.2

Exhibit 8.3

Chapter 9

Exhibit 9.1

Chapter 10

Exhibit 10.3

Exhibit 10.13

Exhibit 10.14

Exhibit 10.17

Exhibit 10.20

Exhibit 10.26

Exhibit 10.27

Exhibit 10.28

Exhibit 10.29

Exhibit 10.30

Exhibit 10.35

Exhibit 10.34

Exhibit 10.37

Chapter 11

Exhibit 11.2

Exhibit 11.1

Exhibit 11.3

Exhibit 11.4

Exhibit 11.5

Chapter 12

Exhibit 12.5

Exhibit 12.11

Chapter 13

Exhibit 13.3

Exhibit 13.9

Exhibit 13.10

Exhibit 13.11

Exhibit 13.12

Exhibit 13.13

Chapter 14

Exhibit 14.1

Exhibit 14.3

Exhibit 14.4

Exhibit 14.5

Exhibit 14.6

Exhibit 14.7

Exhibit 14.8

Exhibit 14.9

Exhibit 14.12

List of Illustrations

Chapter 1

Exhibit 1.1

Sample Scorecard (Partial)

Exhibit 1.2

Gains Chart

Chapter 3

Exhibit 3.1

Major Tasks during Scorecard Development

Chapter 6

Exhibit 6.1

Performance Definition

Exhibit 6.2

Sample Vintage/Cohort Analysis

Exhibit 6.3

Options for Selecting Maturity Curves

Exhibit 6.4

Bad Rate Development

Exhibit 6.8

Roll Rate Chart

Exhibit 6.12

Clustering

Exhibit 6.13

Details for a Cluster

Exhibit 6.14

Segmentation Using Decision Trees

Chapter 8

Exhibit 8.1

Adjusting an Equal Sample to Simulate a 10,000 Through-the-Door Population

Chapter 10

Exhibit 10.1

Scorecard Development Steps

Exhibit 10.2

Finely Binned Loan to Value

Exhibit 10.4

Model Characteristics

Exhibit 10.5

Logical WOE Trend for Age

Exhibit 10.6

WOE for Age of Used Car in Years

Exhibit 10.7

WOE for Debt Service Ratio

Exhibit 10.8

Adjusted WOE for Debt Service Ratio

Exhibit 10.9

WOE Graph for Utilization

Exhibit 10.10

WOE Example

Exhibit 10.11

Illogical WOE Trend for Age

Exhibit 10.12

Logical Trend and Strength

Exhibit 10.15

Inputs for Single Regression

Exhibit 10.16

Reject Inference

Exhibit 10.18

How Swap Set Enables Better Performance

Exhibit 10.19

Factored Sample after Reject Inference

Exhibit 10.21

Extrapolation of Known Bad Rates

Exhibit 10.22

Reject Inference Using Iterative Reclassification

Exhibit 10.23

Odds to Rank-Ordered Input Relationship

Exhibit 10.24

Ln(odds) to Scaled Score Relationship

Exhibit 10.31

Trade-off between Approval and Bad Rate for Two Scorecards

Exhibit 10.32

Kolmogorov-Smirnov Statistic

Exhibit 10.33

ROC Curve

Exhibit 10.36

Validation Chart

Chapter 12

Exhibit 12.1

System Stability Report

Exhibit 12.2

Stability Analysis with Recent History

Exhibit 12.3

Stability Analysis with Lingering Trend

Exhibit 12.4

Stability Analysis Showing Seasonality

Exhibit 12.6

Adjustment of Expected Bad Rates via Recent Vintages

Exhibit 12.7

Sequential Scoring

Exhibit 12.8

Matrix Scoring

Exhibit 12.9

Cutoff Strategy Decisions

Exhibit 12.10

Trade-off Chart

Exhibit 12.12

Credit Line Strategy

Chapter 13

Exhibit 13.1

Typical Model Development Steps

Exhibit 13.2

Typical Model Assessment and Performance Monitoring Steps

Exhibit 13.4

Scorecard Characteristics Ordering Case 1

Exhibit 13.5

Scorecard Characteristics Ordering Case 2

Exhibit 13.6

High-Level Elements of Vendor Scorecard Development Process

Exhibit 13.7

Plot of Good and Bad Score Distributions

Exhibit 13.8

Revolving Credit Utilization

Vendor Calculation Logic

Chapter 14

Exhibit 14.2

System Stability Trend

Appendix A

Exhibit A.1

Internal Bank Scorecard Characteristic Candidates

Exhibit A.2

Credit Bureau Scorecard Characteristic Candidates

Appendix B

Exhibit B.1

Some Selected Variables in the Sample Data Set

Exhibit B.2

WOE Curve and Table for Utilization

Exhibit B.3

WOE Curve and Table for Months Oldest Trade

Exhibit B.4

Output of Logistic Regression Run

Exhibit B.5

Points Distribution for Months Oldest Trade

Exhibit B.6

Points Distribution for Utilization

Guide

Cover

Table of Contents

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Acknowledgments

As with the first edition, I am indebted to many people who have provided ideas, advice, and inspiration for the content of this book.

I would like to thank Dr. Billie Anderson, Dr. Hendrik Wagner, Clark Abrahams, Bradley Bender, and Charles Maner for graciously agreeing to contribute very informative guest chapters to this book.

The Roman poet Ovid once said, “A horse never runs so fast as when he has other horses to catch up and outpace.” I am grateful to the incredibly talented group of people I work with at SAS who continue to enhance my knowledge of risk management and analytics.

I want to thank Nikolay Filipenkov and Clark Abrahams for reviewing this book and providing excellent ideas for improvements.

I continue to learn about the contemporary issues in the industry, the challenges, and innovative ways to deal with them from my customers and colleagues in the credit scoring business. What we know today is due in large part to the generous sharing of knowledge and research work done by credit scoring practitioners. We are indebted to them.

My family—Saleha, Zainab, and Noor—who have been incredibly supportive and tolerant of my frequent work-related absences from home, and have done much of the heavy lifting at home during those times (especially during snowstorms in Markham while I am at warmer locales).

Finally, as always, I want to acknowledge my parents for encouraging me to continuously seek knowledge, and for their constant prayers and blessings, without which there would be no success.

Chapter 1Introduction

“The only virtue of being an aging risk manager is that you have a large collection of your own mistakes that you know not to repeat.”

—Donald Van Deventer

Much has changed since the publication of the first edition of this book in 2006. The use of credit scoring has become truly international, with thousands of lenders now developing their own scorecards in-house. As a benchmark, The SAS Credit Scoring1 solution, which started out around that time, now has hundreds of customers—but more importantly, they are spread out across 60-plus countries. Many more banks, of course, use products from other ­vendors to build and use credit risk scorecards in-house, but in ­general, the trend has moved away from outsourcing the development of scorecards to internal builds. The following factors, listed in the order discussed, have led to more widespread usage of scorecards and the decision by banks to build them in-house.

Factors driving the increased use of scorecards include:

Increased regulation.

Ease of access to sizable and reliable data.

Better software for building scorecards.

Availability of greater educational material and training for would-be developers.

Corporate knowledge management fostering retention and sharing of subject-matter expertise.

Signaling capabilities to external and internal stakeholders.

Efficiency and process improvement.

Creating value and boosting profitability.

Improved customer experience.

In the past decade, the single biggest factor driving banks to bring credit scorecard development in-house has been the Basel II Accord.2Specifically, banks that have opted to (or were told to) comply with the Foundation or Advanced Internal Ratings Based approaches of Basel II were required to internally generate Probability of Default (PD) estimates (as well as estimates for Loss Given Default [LGD] and Exposure at Default [EAD]). Larger banks expanded their production and usage of credit scoring, and were compelled to demonstrate their competence in credit scoring. In many countries, particularly in Europe, even small banks decided to go for these approaches, and thus had to start building models for the first time. This led to some challenges—when you have never built scorecards in-house (and in some cases, not really used them either), where do you start? Many institutions went through significant changes to their data warehousing/management, organizational structure, technology infrastructure, and decision making as well as risk management cultures. The lessons from some of these exercises will be shared in chapters on creating infrastructures for credit scoring, as well as the people who should be involved in a project.

While there is a lot of variance in the way Basel II has been implemented in Europe, it is largely a finished process there.3 Some of the lessons, from Basel II, specifically on how the default definition should be composed will be detailed in a guest chapter written by Dr. Hendrik Wagner. The implementation of Basel II is still ongoing in many countries, where the same exercise is being repeated many times (and in most cases, the same questions are being asked as were 10 years ago in Europe). Many institutions, such as retail credit card and automotive loan companies, that were not required to comply with Basel II, voluntarily opted to comply anyway. Some saw this as a way to prove their capabilities and sophistication to the market, and as a seal of approval on the robustness of their internal processes. But the ones who gained most were those who saw Basel II compliance not just as a mandatory regulatory exercise, but rather as a set of best practices leading to an opportunity to make their internal processes better. This theme of continuous improvement will be addressed in various parts of the book, and guidance given on best practices for the scorecard development implementation process.

In some countries where Basel II was not a factor, local banks decided to take on analytics to improve and be more competitive. In many developing countries, the banking industry became deregulated or more open, which allowed international banks to start operating there. Such banks generally tended to have a long history of using advanced analytics and credit scoring. This put competitive pressures on some of the local banks, which in many cases were operating using manual and judgmental methods. The local banks thus started investing in initiatives such as data warehousing, analytics, and in-house credit scoring in order to bring costs down, reduce losses, and create efficiencies. Another factor that points to a wider acceptance of credit scoring is the tight market for scorecard developers globally. In almost all the countries, whether those with Basel II or not, the demand for experienced credit scoring resources has continued to be high.

In more recent times, the introduction of International Financial Reporting Standards (IFRS) 9 to calculate expected losses has expanded the usage of predictive models within all companies. Those institutions that have already invested in fixing their data problems and establishing sustainable and robust analytics functions will find it easier to comply.

In mature markets, banks that had been developing models and scorecards before have now been looking at how to make the process efficient, sustainable and more transparent. Investments in data warehousing, tools to enable analysts to access the data quickly and easily, integrated infrastructure to reduce model risk, governance processes, and other such areas have increased. Many banks that had invested a lot of money into data warehousing were also looking to increase return on investment (ROI). Credit scoring offered a quick and proven way to use the data, not just for reducing losses but also lead to greater profitability.4

Scarcity of modeling/credit scorecard (these two words are used interchangeably throughout this book) development resources has led institutions to try to reduce human resources risk by using modeling tools that encourage sharing and retention of corporate knowledge, reduce training cycles and costs, and are easier to use. Some of the challenges and risks of developing scorecards in-house will be discussed in the chapter on managing the risks of in-house scoring.

In other banks not specifically impacted by the preceding, increasing competition and growing pressures for revenue generation have led credit-granting institutions to search for more effective ways to attract new creditworthy customers and, at the same time, control losses. Aggressive marketing efforts have resulted in a continuously deeper penetration of the risk pool of potential customers, and the need to process them rapidly and effectively has led to growing automation of the credit and insurance application and adjudication processes. The risk manager is challenged to produce risk adjudication solutions that can not only satisfactorily assess creditworthiness but also keep the per-unit processing cost low, while reducing turnaround times for customers. In some jurisdictions without a credit bureau, the risk manager faces an additional challenge of doing so using data that may not be robust or reliable. In addition, customer service excellence demands that this automated process be able to minimize denial of credit to creditworthy customers, while keeping out as many potentially delinquent ones as possible.

At the customer management level, companies are striving ever harder to keep their existing clients by offering them additional products and enhanced services. Risk managers are called on to help in selecting the “right” (i.e., low-risk) customers for these favored treatments. Conversely, for customers who exhibit negative behavior (nonpayment, fraud), risk managers need to devise strategies to not only identify them but also to deal with them effectively to minimize further loss and recoup any monies owed as quickly as possible.

It is in this environment that credit risk scorecards have continued to offer a powerful, empirically derived solution to business needs. Credit risk scorecards have been widely used by a variety of industries for predicting various types of payment delinquencies, fraud, claims (for insurance), and recovery of amounts owed for accounts in collections, among other things. More recently, as mentioned previously, credit scoring has been used widely for regulatory compliance. Credit scoring offers an objective way to assess risk, and also a consistent approach, provided that system overrides are maintained below acceptable policy-specified thresholds.

In the past, most financial institutions acquired credit risk scorecards from a handful of credit risk vendors. This involved the financial institution providing their data to the vendors, and the vendors then developing a predictive scorecard for delivery. For smaller companies, buying a generic or pooled data scorecard was the only option. While some advanced companies have had internal modeling and scorecard development functions for a long time, the trend toward developing scorecards in-house has become far more widespread in the past few years. Some of the regulatory and operational reasons for this phenomenon were covered at the beginning of this chapter. Others will be discussed later.

First, there are more powerful and easy-to-use data mining software today than ever before. This has allowed users to develop scorecards without investing heavily in advanced programmers and infrastructure. Growing competition and the entry of several new data mining vendors made such tools available at ever cheaper prices. Complex data mining functions became available at the click of a mouse, allowing the user to spend more time applying business and data mining expertise to the problem, rather than debugging complicated and lengthy programs. The availability of powerful “point-and-click”–based Extract-Transform-Load (ETL) software enabled efficient extraction and preparation of data for scorecard development and other data mining. Second, advances in intelligent and easy-to-access data storage have removed much of the burden of gathering the required data and putting it into a form that is amenable to analysis. As mentioned earlier, banks and other lenders have made significant investments in data warehousing and data management, and are now looking to use that data to increase profitability.

Once these tools became available, in-house development became a viable option for many smaller and medium-sized institutions. The industry could now realize the significant ROI that in-house scorecard development could deliver for the right players. Experience has shown that in-house credit scorecard development can be done faster, cheaper, and with far more flexibility than any outsourcing strategy. Development was cheaper since the cost of maintaining an in-house credit scoring capability was less than the cost of purchased scorecards. Internal development capability also allowed companies to develop far more scorecards (with enhanced segmentation) for the same expenditure. Scorecards could also be developed more rapidly by internal resources using the right software—which meant that better custom scorecards could be implemented more rapidly, leading to lower losses.

In addition, companies have increasingly realized that their superior knowledge of internal data and business insights led them to develop better-performing scorecards. Seasoned modelers understand that the single biggest contributor to model quality is the data itself, followed by the knowledge level of the analyst of that data. This book will cover in detail how internal knowledge can be applied to build better scorecards. In every phase of the project, we will discuss how appropriate judgment can be applied to augment statistical analyses.

Better-performing scorecards also came about from having the flexibility to experiment with segmentation and then following through by developing more finely segmented scorecards. Deeper segmentation allows for more fine-tuned predictions and strategies. Combined with software that can implement champion/challenger scorecards, this becomes a great way to experiment with different configurations of models. Performing such detailed segmentation analysis through external vendors can become expensive.

Banks have also realized that credit risk scorecards are not a commodity to be purchased from the lowest bidder—they are a core competence and knowledge product of the institution. Internal scorecard development increases the knowledge base within organizations. The analyses done reveal hidden treasures of information that allow for better understanding of customers’ risk behavior and lead to better strategy development. We will cover some of this knowledge discovery in the section on model development, specifically the grouping process.

In summary, leaving key modeling and strategy decisions to “external experts” can prove to be a suboptimal route at best, and can also be quite costly.

This book presents a business-focused process for the development and usage of credit risk prediction scorecards, one that builds on a solid foundation of statistics and data mining principles. Statistical and data mining techniques and methodologies have been discussed in detail in various publications and will not be covered in depth here. I have assumed that the reader is either familiar with these algorithms, or can read up on them beforehand, and is now looking for business knowledge pertaining to scorecard development.

The key concepts that will be covered in the book are:

The application of business intelligence to the scorecard development process, so that the development and implementation of scorecards is seen as an intelligent business solution to a business problem. Good scorecards are not built by passing data solely through a series of programs or algorithms—they are built when the data is passed through the analytical and business-trained mind of the user. This concept will be applied in all the sections of this book—taking statistical analyses and overlaying business knowledge on it to create better results.

Building scorecards is a business process—as much as we use statistical algorithms, simple or complex, to build models, at the end of the day it is a business exercise. The purpose of the exercise is to enable a better business decision and not merely the creation of a great formula. As such, each process—whether selecting a “bad” definition, deciding appropriate segmentations, best bins for attributes, or the best scorecard—will be viewed through the lens of a business decision.

Collaborative scorecard development, in which end users, subject matter experts, implementers, modelers, validators, decision makers and other stakeholders work in a cohesive and coherent manner to get better results and avoid costly setbacks and potential disasters during the process.

The concept of building a risk profile—this means building scorecards that contain predictive variables representing major information categories, usually between 8 and 15 variables. This mimics the thought processes of good risk adjudicators, who analyze information from credit applications or customer behavior and create a profile based on the different types of information available. They would not make a decision using four or five pieces of information only—so why should anyone build a scorecard that is narrow based? In statistics, parsimonious models are usually preferred. However, in this case, where the modeler is attempting to more fully capture the business reality, more variables are preferred in order to construct a proper and representative risk profile. The point of the exercise is to make the best decision-making tool possible, not just a statistical one.

Anticipating impacts of decisions and preparing for them. Each decision made—whether on the definition of the target variable, segmentation, choice of variables, transformations, choice of cutoffs, or other strategies—starts a chain of events that impacts other areas of the company as well as future performance. By tapping into corporate intelligence and working in collaboration with others, the user will learn to anticipate the impact of each decision and prepare accordingly to minimize disruption and unpleasant surprises.

View of scorecards as decision support tools. Scorecards should be viewed as a tool to be used for better decision making and should be created with this view. This means they must be understood and controlled; scorecard development should not result in a complex model that cannot be understood enough to make decisions or perform diagnostics.

Individual scorecard development projects may need to be dealt with differently, depending on each company’s unique situation—for example, amount and type of data available, knowledge level, staff, and regulatory limitations. This methodology should therefore be viewed as a set of “best-practice” guidelines rather than as a set of definitive rules that must be followed. Many processes and calculations described in this book can be changed and customized by individual users once they understand what is going on. Finally, it is worth noting that regulatory compliance plays an important part in ensuring that scorecards used for granting consumer credit are statistically sound, empirically derived, and capable of separating creditworthy from noncreditworthy applicants at a statistically significant rate.5 Users should be aware of the regulations that govern models in their jurisdictions, and change the process accordingly.

Scorecards: General Overview

Credit risk scoring, as with other predictive models, is a tool used to evaluate the level of credit risk associated with applicants or customers. While it does not identify “good” (no negative behavior expected) or “bad” (negative behavior expected) applications on an individual basis, it provides statistical odds, or probability, that an applicant with any given score will be “good” or “bad.” These probabilities or scores, along with other business considerations such as expected approval rates, profit, churn, and losses, are then used as a basis for decision making.

In its simplest form, a scorecard consists of a group of characteristics, statistically determined to be predictive in separating good and bad accounts. For reference, Exhibit 1.1 shows a part of a scorecard.

Exhibit 1.1 Sample Scorecard (Partial)

Scorecard characteristics may be selected from any of the sources of data available to the lender at the time of the application. Examples of such characteristics are demographics (e.g., age, time at residence, time at job, postal code), existing relationship (e.g., time at bank, number and types of products, payment performance, previous claims), credit bureau (e.g., inquiries, trades, delinquency, public records), real estate data, and so forth. The selection of such variables and creation of scorecards will be covered in later chapters in much more detail.

Each attribute (“age” is a characteristic and “23–25” is an attribute) is assigned points based on statistical analyses, taking into consideration various factors such as the predictive strength of the characteristics, correlation between characteristics, and operational factors. The total score of an applicant is the sum of the scores for each attribute present in the scorecard for that applicant.

Exhibit 1.2 is an example of the gains chart, one of the management reports produced during scorecard development.

The gains chart, which will be covered in more detail in later chapters, tells us the expected performance of the scorecard. Several things can be observed from this exhibit:

The score bands have been arranged so that there are approximately 10 percent of accounts in each bucket. Some analysts prefer to arrange them in equal score bands.

The marginal bad rate, shown in the column “marginal event rate,” rank orders from a minimum of 0.2 percent to a maximum of about 15.7 percent. There is some variability between the bad rate based on counts and the predicted bad rate from the model (average predicted probability) due to low counts.

For the score range 163 to 172, for example, the expected marginal bad rate is 5.31 percent. This means 5.31 percent of the accounts that score in that range are expected to be bad.

For all accounts above 163, the cumulative bad rate, shown in the column “cumulative event rate,” is 2.45 percent. This would be the total expected bad rate of all applicants above 163.

If we use 163 as a cutoff for an application scorecard, the acceptance will be about 70 percent, meaning 70 percent of all applicants score above 163.

Exhibit 1.2 Gains Chart

Based on factors outlined above, as well as other decision metrics to be discussed in the chapter on scorecard implementation, a company can then decide, for example, to decline all applicants who score below 163, or to charge them higher pricing in view of the greater risk they present. “Bad” is generally defined using negative performance indicators such as bankruptcy, fraud, delinquency, write-off/charge-off, and negative net present value (NPV).

Risk score information, combined with other factors such as expected approval rate and revenue/profit potential at each risk level, can be used to develop new application strategies that will maximize revenue and minimize bad debt. Some of the strategies for high-risk applicants are:

Declining credit/services if the risk level is too high.

Assigning a lower starting credit limit on a credit card or line of credit.

Asking the applicant to provide a higher down payment or deposit for mortgages or car loans.

Charging a higher interest rate on a loan.

Charging a higher premium on insurance policies.

Adjusting payment terms for business customers.

Asking the applicant to provide a deposit for water/electricity utilities services, or for landline phones.

Offering prepaid cellular services instead of postpaid, or offering a lower monthly plan.

Denying international calling access from telecommunications companies.

Asking high-risk applicants for further documentation on employment, assets, or income.

Selecting applicants for further scrutiny for potential fraudulent activity.

Conversely, high-scoring applicants may be given preferential rates and higher credit limits, and be offered upgrades to better products, such as premium credit cards, or additional products offered by the company.

Application scores can also help in setting “due diligence” policies. For example, an applicant scoring very low can be declined outright, but those in middling score ranges can be approved but with additional documentation requirements for information on real estate, income verification, or valuation of underlying security.

The previous examples specifically dealt with credit risk scoring at the application stage. Risk scoring is similarly used with existing clients on an ongoing basis. In this context, the client’s behavioral data with the company, as well as bureau data, is used to predict the probability of ongoing negative behavior. Based on similar business considerations as previously mentioned (e.g., expected risk and profitability levels), different treatments can be tailored to existing accounts, such as:

Offering product upgrades and additional products to better customers.

Increasing or decreasing credit limits on credit cards and lines of credit.

Allowing some revolving credit customers to go beyond their credit limits for purchases.

Allowing better customers to use credit cards even in delinquency, while blocking the high-risk ones immediately.

Flagging potentially fraudulent transactions.

Offering better pricing on loan/insurance policy renewals.

Setting premiums for mortgage insurance.

Deciding whether or not to reissue an expired credit card.

Prequalifying direct marketing lists for cross-selling.

Directing delinquent accounts to more stringent collection methods or outsourcing to a collection agency.

Suspending or revoking phone services or credit facilities.

Putting an account on a “watch list” for potential fraudulent activity.

In addition to being developed for use with new applicants ­(application scoring) or existing accounts (behavior scoring), ­scorecards can also be defined based on the type of data used to develop them. “Custom” scorecards are those developed using data for customers of one organization exclusively, for example, if a bank uses the performance data of its own customers to build a scorecard to predict bankruptcy. It may use internal data or data obtained from a credit bureau for this purpose, but the data is only for its own ­customers.

“Generic” or “pooled data” scorecards are those built using data from multiple lenders. For example, four small banks, none of which has enough data to build its own custom scorecards, decide to pool their data for auto loans. They then build a scorecard with this data and share it, or customize the scorecards based on unique characteristics of their portfolios. Scorecards built using industry bureau data, and marketed by credit bureaus, are a type of generic scorecards. The use of such generic models (and other external vendor built models) creates some unique challenges as some of the know-how and processes can remain as black boxes. We will discuss how to validate and use such models in a guest chapter authored by experienced industry figures Clark Abrahams, Bradley Bender, and Charles Maner.

Risk scoring, in addition to being a tool to evaluate levels of risk, has also been effectively applied in other operational areas, such as:

Streamlining the decision-making process, that is, higher-risk and borderline applications being given to more experienced staff for more scrutiny, while low-risk applications are assigned to junior staff. This can be done in branches, credit adjudication centers, and collections departments.

Reducing turnaround time for processing applications through automated decision making, thereby reducing per-unit processing cost and increasing customer satisfaction.

Evaluating quality of portfolios intended for acquisition through bureau-based generic scores.

Setting economic and regulatory capital allocation.

Forecasting.

Setting pricing for securitization of receivables portfolios.

Comparing the quality of business from different channels/regions/ suppliers.

Help in complying with lending regulations that call for empirically proven methods for lending, without potentially discriminatory judgment.

Credit risk scoring, therefore, provides lenders with an opportunity for consistent and objective decision making, based on empirically derived information. Combined with business knowledge, predictive modeling technologies provide risk managers with added efficiency and control over the risk management process.

Credit scoring is now also being used increasingly in the insurance sector for determining auto6 and home insurance7 premiums. A unique study conducted by the Federal Reserve Board even suggests that couples with higher credit scores tend to stay together longer.8

The future of credit scoring, and those who practice it, is bright. There are several issues, discussed later, that will determine the shape of the industry in the coming 5- to 10-year span.

The rise of alternate data sources, including social media data, will affect the industry. In reality, the change has already begun, with many lenders now starting to use such data instead of the more traditional scores.9 This issue will be discussed in more detail in several chapters. In many countries, the creation of credit bureaus is having a positive impact on the credit industry. Having a centralized repository of credit information reduces losses as lenders can now be aware of bad credit behavior elsewhere. Conversely, it makes it easier for good customers to access credit as they now have strong, reliable evidence of their satisfactory payment behavior. In addition, the access to very large data sets and increasingly powerful machines has also enabled banks to use more data, and process analytics faster. We will cover this topic in more detail in its own chapter authored by Dr. Billie Anderson.

Regulatory challenges will continue, but banks are better prepared. Basel II has overall improved the level of analytics and credit scoring in banks. It has introduced and formalized repeatable, transparent, and auditable processes in banks for developing models. It has helped create truly independent arm’s-length risk functions, and model validation team that can mount effective challenges. Basel II, as well as Basel Committee on Banking Supervision (BCBS) regulation 239,10 has also made data creation, storage, and aggregation at banks far better than before. IFRS 9 and other current regulatory initiatives such as Comprehensive Capital Analysis and Review (CCAR), Current Expected Credit Loss (CECL), and stress testing, as well as their global equivalents, will continue to expand and challenge analytics and credit scoring.

One factor that users of credit scoring will need to be cautious about is the increasing knowledge of credit scoring in the general population. In particular, in the United States, knowledge of bureau scores such as the FICO score, is getting very common. This is evidenced by the number of articles, discussions, and questions on how to improve the score (I personally get such questions via e-mail and on social media at least every week or two weeks—questions such as “How do I maximize my score in the shortest time?”; “If I cancel my card, will it decrease my score”; etc.). This factor can work in two ways. On the positive side, it may drive people to improve their payment and other credit habits to get better scores. On the negative side, this may also lead to manipulation. The usage of robust bureau data will mitigate some of the risk, while the usage of unreliable social media or demographics data may not.

The ever-present discussion on newer, better algorithms will continue. Our quest to explain data better, and differentiate useful information from noise, has been going on for decades and will likely go on for decades more. The current hot topic is machine learning. Whether it or the other more complex algorithms replaces the simpler algorithms in use in credit scoring will depend on many factors (this topic will also be dealt with in the later chapter on vendor model validation). Banks overwhelmingly select logistic regression, scorecards, and other such methods for credit scoring based on their openness, simplicity, and ease of compliance. Complex algorithms will become more popular for nonlending and nonregulatory modeling, but there will need to be a change in regulatory and model validation mind-sets before they become widely acceptable for the regulatory models.

The credit crisis of 2008 has been widely discussed and dissected by many others. Let us firstly recognize that it was a complex event and its causes many. Access to cheap money, a housing bubble in many places, teaser rates to subprime borrowers, lack of transparency around models, distorted incentives for frontline staff, unrealistic ratings for mortgage-backed securities, greed, fraud, and the use of self-declared (i.e., unconfirmed) incomes have all been cited.11 Generally, I consider it a failure of both bankers in exercising the basic rules of banking, and risk management in failing to manage risks. Some have even suggested that models and scorecards are to blame. This is not quite accurate and reflects a failure to understand the nature of models. As we will cover in this book, models are built on many underlying assumptions, and their use involves just as many caveats. Models are not perfect, nor are they 100 percent ­accurate for all times. All models describe historical data—hence the critical need to adjust expectations based on future economic cycles. The amount of confidence in any model or scorecard must be based on both the quality and quantity of the underlying data, and decision-making strategies adjusted accordingly. Models are very useful when used judiciously, along with policy rules and judgment, recognizing both their strengths and weaknesses. The most accurate model in the world will not help if a bank chooses not to confirm any information from credit applicants or to verify identities. As such, one needs to be very realistic when it comes to using scorecards/models, and not have an unjustified level of trust in them.

“… too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them.”

—Lloyd Blankfein, CEO Goldman Sachs (Financial Times, February 8, 2009)

Notes

1

.

www.sas.com/en_us/industry/banking/credit-scoring.html

2

. Basel Committee for Banking Supervision, Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Bank for ­International Settlements, November 2005.

3

. European Banking Federation, Study on Internal Rating Based (IRB) models in ­Europe, 2014.

4

. L. Einav, M. Jenkins, J. Levin, ”The Impact of Credit Scoring on Consumer ­Lending,”

RAND Journal of Economics

, 44, no. 2, (Summer 2013): 249–274.

5

. Reg. B, 12 C.F.R. §202.2(p)(2)(iii)(1978)

6

.

http://time.com/money/3978575/credit-scores-auto-insurance-rates/

7

.

www.cbc.ca/news/credit-scores-can-hike-home-insurance-rates-1.890442

8

. Jane Dokko, Geng Li, and Jessica Hayes, “Credit Scores and Committed ­Relationships,” Finance and Economics Discussion Series 2015-081. Washington, DC: Board of Governors of the Federal Reserve System, 2015;

http://dx.doi.org/10.17016/FEDS.2015.081

9

.

www.wsj.com/articles/silicon-valley-gives-fico-low-score-1452556468

10

. Basel Committee on Banking Supervision document, BCBS 239, Principles for Effective Risk Data Aggregation and Reporting, Bank for International Settlements, January 2013.

11

.

www.forbes.com/sites/stevedenning/2011/11/22/5086/#c333bf95b560

Chapter 2Scorecard Development: The People and the Process

“Talent wins games, but teamwork and intelligence wins championships.”

—Michael Jordan

Many years ago, I developed a set of scorecards for a risk management department of a bank. The data sent to us by the risk folks was great, and we built a good scorecard with about 14 reasonable variables. About two weeks after delivering the scorecard, we got a call from the customer. Apparently, two of the variables that they had sent to us in the data set were not usable, and we needed to take them out. I have had bankers tell me stories of changing scorecard variables because information technology (IT) gave them estimates of three to four months to code up a new derived variable. IT folks, however, tell me they hate to be surprised by last-minute requests to implement new scorecards or new derived variables that cannot be handled by their systems. Almost every bank I’ve advised has had occasions where the variables desired/expected by the risk manager could not be in models, where models built could not be used because other stakeholders would not agree to them, or where other surprises lay waiting months after the actual work was done.

These are some of the things that cause problems during scorecard development and implementation projects. In order to prevent such problems, the process of scorecard development needs to be a collaborative one between IT, risk management (strategy and policy), modeling, validation, and operational staff. This collaboration not only creates better scorecards, it also ensures that the solutions are consistent with business direction, prevent surprises, and enable education and knowledge transfer during the development process. Scorecard development is not a “black box” process and should not be treated as such. Experience has shown that developing scorecards in isolation can lead to problems such as inclusion of characteristics that are no longer collected, legally suspect, or difficult to collect operationally, exclusion of operationally critical variables, and devising of strategies that result in “surprises” or are unimplementable. In fact, since the credit crisis of 2007–2008, the tolerance at most banks for complex/black box models and processes is gone. The business user expects a model that can be understood, justified, and where necessary, be tweaked based on business considerations, as well as an open and transparent process that can be controlled.

In this chapter, we will look at the various personas that should be involved in a scorecard development and implementation project. The level of involvement of staff members varies, and different staff members are required at various key stages of the process. By understanding the types of resources required for a successful scorecard development and implementation project, one will also start to appreciate the business and operational considerations that go into such projects.

Scorecard Development Roles

At a minimum, the following main participants are required.

Scorecard Developer

The scorecard developer is the person who performs the statistical analyses needed to develop scorecards. This person usually has:

Some business knowledge of the products/tasks for which models are being developed. For example, if someone is responsible for building models for an auto loan product or a mobile phone account, they should be familiar with the car-selling business or the cell phone/telco business. Similarly, a person building scorecards for collections needs to understand the collections process. This is to make sure that they understand the data and can interpret it properly in the context of each subject. This would include knowing which types of variables are generally considered important for each product, how decisions and data collection at source impacts quality, and how the model will be used for decision making.

An in-depth knowledge of the various databases in the company and the data sets being used. The single most important factor in determining the quality of the model is the quality of the data. When the users understand the quirks in the data, where and how the data was generated, deficiencies, biases, and interpretation of the data, they will be able to conduct intelligent analysis of that data. Otherwise, their analysis will be devoid of context. This task may also be covered by someone other than the scorecard developer—for example, a data scientist playing an advisory role.

An in-depth understanding of statistical principles, in particular those related to predictive modeling. For example, knowledge of logistic regression, fit statistics, multicollinearity, decision trees, and so on.

A good understanding of the legal and regulatory requirements of models and of the model development process. This includes documentation requirements, transparency, and any laws that control the usage of certain information. For example, in many countries the use of gender, marital status, race, ethnicity, nationality, and the like are prohibited. They would also need to know requirements expected by internal model validation teams so that minimum standards of model governance are met. Detailed knowledge of this subject is usually with model validation groups.

Business experience in the implementation and usage of risk models. This is related to the business knowledge of the product. If analysts understand the end use of the model, it enables them to develop the one best suited for that task. The analyst will not develop a model that merely meets statistical acceptance tests.

This person ensures that data is collected according to specifications, that all data quirks are taken into account, and that the scorecard development process is statistically valid.

Data Scientist

The data scientist is the person who helps source and extract the required records and fields of information in order to populate the scorecard development database. This person usually has:

An in-depth knowledge of the various databases in the company, and the data sets being used.

Proficiency in the tools and systems to determine and document data lineage, to perform field-specific code mappings to common values and definitions from a variety of internal legacy transaction systems and external data reporters.

Ability to merge/combine information from disparate sources and perform necessary preprocessing to deal with data issues, such as undefined codes, missing information, or extreme/suspect values.

Familiarity with file formats and fields of information available from the different credit bureaus, rating agencies, and other third-party data providers.

A good example of the required knowledge for data sourcing and extraction is in mortgage lending, where there can be up to four co-applicants, and records for each must be found and joined into a single complete applicant record with individual and combined characteristics derived. These include characteristics such as combined loan-to-value ratio, combined income, payment to combined income, combined debt-to-income ratio, and payment shock to combined current housing payments. Even in a data warehouse, the co-applicant records may reside in a different table that the primary applicant record and matching logic must be used to associate related records. Typical scorecard developers do not possess this type of in-depth knowledge, especially in the larger, more complex financial institutions.

Product or Portfolio Risk Manager/Credit Scoring Manager

Risk managers are responsible for the management of the company’s portfolio and usage of scorecards. They are usually responsible for creating policies and strategies for approvals, credit limit setting, collections treatment, and pricing. In most companies, this person would be the business owner of the scorecard. This person usually has:

Subject matter expertise in the development and implementation of risk strategies using scores.

An in-depth understanding of corporate risk policies and ­procedures.

An in-depth understanding of the risk profile of the company’s customers and applicants for products/services.

A good understanding of the various implementation platforms for risk scoring and strategy implementation in the company.

Knowledge of legal issues surrounding usage of particular characteristics/processes to adjudicate credit applications.

Knowledge of credit application processing and customer management processes in the company.

Knowledge of roll rate models; delinquency trends by product, region, and channel; and reports and the average time to charge-off.