1. Prepared by John Anderson, Queensland University of Technology

2. Credit Scoring Techniques
Chapter Three
Credit Scoring Techniques

3. Learning Objectives List the development of credit scoring techniques
Discuss the behavioural aspects of credit scoring
Explain the imperative for credit scoring

4. Learning Objectives
Discuss the application of credit scoring techniques
List the various modelling techniques used for credit scoring
Discuss the steps to take in implementing a credit scoring process

5. Introduction
The use of statistical credit scoring techniques allows for rigorous and disciplined decision-making
The concept of informal credit scoring has a long history
Computer advances in 1980s saw far greater application of formal credit scoring techniques

6. Overview
Credit scoring generally used as a statistical method of ranking the probability of loan repayment/default with three basic characteristics:
Must not rely on prohibited information (e.g. race, religion, gender)
Must contribute positively to a client’s creditworthiness
Credit extended should contribute positively to the lending institution

7. Overview
Ultimate aim of credit scoring is to improve the credit quality of the lending institution’s loan book
Credit scoring is increasingly moving from consumer lending to small business and even to corporate lending activities.

8. The Development of Statistical Credit Scoring
Statistical developments in the 1930s–1940s allowed identification of good/bad loans
Significant growth in post-WWII consumer credit such as credit cards
Provided a non-emotive, rigorous and statistically valid method for determining credit decisions

9. The Development of Statistical Credit Scoring
Computing technology in 1980s allowed development of sophisticated credit scoring methods
Provided more accurate credit pricing so that risk premia reflected borrower’s risk characteristics
Led to credit staff becoming more sales focused than credit focused

10. Behavioural Aspects of Credit Scoring
Early resistance to impersonal credit scoring techniques
Traditional ‘relationship’ approach to lending became too expensive
Became much more widely accepted after spectacular judgment-based lending failures during the 1980s

11. The Imperative for Credit Scoring
Significant improvements in credit scoring allowed:
Better risk identification within the loan portfolio
Improved targeting of client groups
Increased loan volume with lower costs
Reduction in time for loan decisions
Rigorous fine-tuning of loan decisions

12. Statistical Credit Scoring versus Judgment Methods
The shift from a more qualitative to quantitative approach reveals:
Better use of information including better determination of what are relevant data
Easier to access high-volume lending
Reasons for the default of classes of borrowers can be more readily determined
Improved management control over the loan portfolio’s performance and methods employed in future credit decisions

13. Statistical Decision-Making In Credit Scoring Models
Statistical decision-making models quantitatively model risk and uncertainty to give a picture of future probabilities.
Hoyland (1997) identified thirteen main methods used in statistical decision-making models.

14. Statistical Decision-Making In Credit Scoring Models
1 – Probability Modelling
This modelling aims to predict the future value of cashflows emanating from the firm
Identifies controllable (e.g. credit risk stance) and uncontrollable factors (e.g. interest rates) to create loan’s risk profile
2 – Application Credit Scoring Models
Analyses historical loan decisions and compares those to estimated default rates
Fails to be forward-looking

15. Statistical Decision-Making In Credit Scoring Models
3 – Application Derivatives
(a) Mail Solicitation Score — Modelling the success of cross-selling mail promotions
(b) Attrition Models — Predicts the success of products over the product’s lifecycle
(c) Authorisation Scores — Determining types and levels of access to funds (particularly credit levels) via mechanisms such as EFTPOS

16. Statistical Decision-Making In Credit Scoring Models
4 – Judgemental Credit Scoring
An estimated model is employed when new products introduced and less than three years data available
5 – Collection Models
Specialist models employed to determine best strategy once loan in default, such as ruthless early term follow-up, early warning leading, to total debt write-off

17. Statistical Decision-Making In Credit Scoring Models
6 - Regression Analysis
Use of this linear statistical technique to identify simple ratios, such as age to probability of default, to determine risk levels
7 – Logistic Regression
Allows direct estimation of probabilities by permitting nonlinear model estimation by the use of interpolation or iterative processes

18. Statistical Decision-Making In Credit Scoring Models
8 - Decision Tree Models
Categorises the attributes of a client from most to least important until sufficient branches allow for reasoned decision
9 – Neural Networks
Relatively new assumption-free approach to credit modelling that ‘learns’ from a training data set to identify characteristics of defaulting loans

19. Statistical Decision-Making In Credit Scoring Models
10 – Genetic Algorithms
Evolutionary approach relying on Artificial Intelligence (AI) dealing directly with its environment and able to control for events such as changes in interest rates or macroeconomic variables
11 – Mortality Models
Assesses actual bond repayment histories to determine the appropriate level of risk premium required for corporate debt

20. Statistical Decision-Making In Credit Scoring Models
12 – Chi-Square Automatic Interaction Detector (CHAID)
Determines best predictor of an event and splits these into two groups. This process is repeated on these two groups and so on
13 – Expert Systems
Computer-based decision-tree support systems incorporating an information module, information database module and a learning model

21. Social and Ethical Issues in Credit Scoring
While credit scoring produces unbiased results, it may:
Alienate staff who see themselves as ‘lenders’ and not ‘salespeople’
Increase the perceived impersonal relationship between banker and its staff and clients
Produce ‘type I’ and ‘type II’ errors
Do lenders occasionally need to think behind the credit score numbers?

22. Implementing Credit Scoring Within the Organisation
A number of steps should be considered when implementing a credit scoring system into an organisation, including:
Board and executive management agree on project scope
Use of multidisciplinary implementation teams
Ensure affected interest groups have input into affected lending areas

23. Implementing Credit Scoring Within the Organisation
Incorporation of existing credit rules to reflect the institution’s values
Meticulous training of clerical staff who will assist in creating the lending database
Rigorous testing of the database to identify various performance groups, i.e. good v. bad v. rejections
Rigorous testing of the draft scoring formulation, with results presented to senior management to strengthen support

24. Implementing Credit Scoring Within the Organisation
Comparing current loan acceptance rates with those produced by the model and fine-tuning of cut-off rates
Develop implementation procedures, IT infrastructure and conduct sample implementation
Refine credit scoring operational procedures
Develop ‘exceptions’ and over-ride rules
Implement across lending institution

25. Implementing Credit Scoring Within the Organisation
Ultimately, the Credit scoring system must assess unknown individuals and produce a consistent credit assessment result.
The credit scoring process is one that will evolve over time to incorporate new information and be used in other lending activities.