An Economic Model for Credit Assessment Problems Using Screening Approaches

Author(s): H. -T. Tsai, L. C. Thomas and H. -C. Yeh

Source: The Journal of the Operational Research Society, Vol. 56, No. 7 (Jul., 2005), pp. 836-843
Published by: Palgrave Macmillan Journals on behalf of the Operational Research Society
Stable URL: http://www.jstor.org/stable/4102184
Accessed: 09-01-2016 05:32 UTC

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Journal of the Operational Research Society (2005), 836-843 k 2005 OperationalResearchSociety Ltd.All rightsreserved.0160-5682/05 $30.00

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An economic model for credit assessment

problems using screening approaches

H-T Tsai', LC Thomas2* and H-C Yeh3
'NationalSun Yat-SenUniversityKaohsiung,Taiwan,ROC;2Universityof Southampton,UK;and3National
PingtungInstituteof Commerce,Taiwan,ROC
How to combinevaryingcreditinformationcollectedfromvarioussourcesat differenceperiodsfor the purposeof
creditassessmentis an importantissuefor somefinancialcompanies.In this article,the screeningproceduresusing
individualcutandlinearcutapproaches areproposedto solvetheissueandto controldefaultratesin creditassessment
problems.Then,an economicscreening modelis providedto incorporatewiththeproposedapproaches so thatoptimal
cutoffpointsaredetermined by maximizing totalprofit.An exampleof a loanprogramme is illustratedthe use of the
proposedeconomicscreeningprocedures. The resultsshowthat the linearcut approachuniformlyoutperformsthe
individualcut approachin termsof totalprofitandcomputation complexity.Moreover,thelinearcut approachcanbe
easilyextendedto the casewithmultiplevariablesandthe solutionis also in a closedform.Therefore,the screening
procedureusingthe linearcut approachis stronglyrecommended for creditassessmentproblems.
Journalof theOperational ResearchSociety(2005)56, 836-843.doi:10.1057/palgrave.jors.2601911
Publishedonline1 December2004

credit;scoring;scorecard;
Keywords: screening

Introduction hand for predictingan application'sdefaultingprobability

In a creditassessmentprocess,a creditscorecardis normally
constructedfrom a huge database with multiple variables
and is often used to assess personal credit. Traditionally,
discriminantand regression analyses have been the most
widelyused techniquesfor buildingscorecards.For example,
Lane,' Apilado et al2 applied discriminant analysis to
construct their credit scoring models. Orgler3proposed a
model for commercial loans by using regressionanalysis,
and Orgler4used regressionanalysisto constructa scorecard
for evaluatingoutstandingloans, ratherthan screeningnew
applicants.Wiginton5used one of the publishedaccounts of
logistic regression applied to credit scoring in a compar-
ison with discriminant analysis. However, development,
revision,and maintenanceof a commercialcredit scorecard
are costly, and are normally handled by a special credit
bureauor agent.
Collecting various credit information from various
sources at differentperiods is necessaryfor some financial
companies to assess an applicant's credit. For example,
credit scorecardsor bureau data may be purchased from
credit bureausor agents; applicationdata may be obtained
from applicantsdirectly;after creditis granted,behavioural
informationmay be collected for furthercredit assessment,
etc. Therefore,how to combine all availableinformationon
*Correspondence:LC Thomas, School of Management, University of
Southampton, UK.
E-mail:L.Thomas(soton.ac.uk
becomes an importantissue.
Suppose there exists an extra useful predictive variable
other than the existingscorecarditself, we have two ways to
incorporateit into the existing scorecard:(1) if the whole
database, which contains all detailed data for constructing
the scorecard,is available, then the extra variable can be
incorporateinto the scorecard.The credit bureau or agent
normally does this update work at the development or
revisionstage;(2) if the score itself is availableonly, it can be
treated as a single variable, then both score variable and
predictivevariablemay jointly be used to predictdefaulting
probability. The scorecard users do this work at the
applicationstage.
Other than an overall credit score, O'Connor6found out
that incomeratio has a negativerelationshipwith bad rate in
a lending environment. Hence, the matrix approach was
applied to explore the relationshipsamong bad rates (bad
number rate or bad advance rate) versus two predictive
variablesof overallcreditscore and income ratio, in which a
cross table of overall credit score by income ratio was
constructed,both bad rateswere computedin each cell, then
two distinctgroupsof applicantswereidentifiedaccordingto
the bad advance rate and were set different credit limits.
Bennett et afl also applied the matrix approach to select a
mailing list with high response and low default rate using
both mailingresponsescore (Equifaxbureaudata) and risk
score (CCN bureau data). However, the matrix approach,

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 H-TTsaiet a/-Aneconomic
model
forcredit
assessment
problem837

using discrete scale and individual cut point for each cannot be measured directly. Variable Y is linked to the
variable,has some limitationsand is not easily extendedto observed binary variable Y* by the following index
the case with more than two variables. function:
From the scorecard users point of view, the issue of
combining all possible credit information is taken into 1 if Y>k
considerationto predict defaultingprobabilityand then to 1- 0 if Y (1)
maximize profit. In this article, screeningproceduresusing where k, is the upper specification•k or threshold of Y. An
individual cut and linear cut approaches are proposed to
applicantwith Y> k, will default and the others will not, so
deal with the above issue. Furthermore, an economic the overall default rate is given by i = P[Y> ky].
screening model based on default rate is proposed and Without loss of generality,let (Y, X1, X2, ..., Xk) have the
optimal cutoff points are determined so that the better standardmultivariatenormal distributionwith a correlation
applicantscould be selectedby maximizingtotal profit. matrix
1 Poi P02 . . . POk
Screening technology Pol 1 P12 . . . Plk
P02 P12 . . P2k 1
Screeninghas been wildly used in quality control, psychol- F-12 (2)
ogy, education, and medicine and so forth. It is a way of -21
122

selecting items whose performance variable is within

specificationsby observingone or more correlatedscreening
variablesinstead of the performancevariabledirectly.There
has been considerable research in the area of screening,
beginning with Taylor and Russell8 and followed by the
classic work of Owen et al,9 who developeda methodology
and readilyusable tables for one or two screeningvariables
under one-sided specificationand normality assumptions.
They suggested two methods that use two screening
variables:the firstmethod uses a screeningrule that requires
an accepted item to conform to the individual screening
levels (or specifications)and the secondmethod is based on a
linearcombinationof two screeningvariables.Thomaset alo'
used similar methods and provided Taylor-Russell-type
tables to predict future individualperformanceby educa-
tional tests. Also, Tang1"studied the economic screening
model based on the concept of cost minimizationto choose
optimal screeninglevels. Moskowitz and Tsai'2 proposed a
double screeningmodel based on individualmisclassification
error, and then Moskowitz et al'3 extended the result to a
multistagescreeningmodel for the detectionof hypertension.
Latterly, Tsai and Yeh'4 proposed a two-stage economic
screening model to solve a mailing credit assessment
problem that involves both mailing stage and credit
assessment stage. The proposed model has a significant
improvementin terms of responserate, declinerate, default
rate and total profit.
Credit assessment screening procedures
To facilitatethe presentation,some notations and assump-
tions are summarizedbelow:
Y: tendencyto default,
X= {Xi, i-1,2,..., k}, credit score, bureau data, beha-
viour score, applicationdata, etc.
All Xi's are predictive screening variables that are
correlatedwith the latent (unobserved)variable Y, which
POk Plk P2k . . .
For the groupeddata, the simplecorrelationsp in (2) can be
estimatedusing the binaryprobit model in Long.'5 For the
jth group, let xj denote the middle value of a predictive
screeningvariable, and rj denote its default rate; then the
latent variable can be estimated by yjdI-l(r1) + ky, and
p can be computed using the paired data of (xij,y), where
OI-'(.) denotes the inverse standard normal distribution
function.
Our objectiveis to obtain a group of consumerswho have
better credit by way of selecting those having qualified
screening variables. Due to the limited budget, space, or
number of products available, the acceptancerate is often
prespecifiedin advance and is denoted by P/. Next, the
screening procedures using individual cut and linear cut
approaches will be proposed to predict the risk of bad
debt.
Individualcut approach
(a) Two ScreeningVariables
Let X, and X2 denote two screening variables with the-
larger-the-bettercharacteristics.The individualcut approach
is to select appropriateobjects whose predictivescores are
within individualcutoff points, respectively,as in Figure 1.
For the case of two screeningvariables,an individualcut
approachis similarto a matrixapproachexcept that it uses
continuous screeningvariables.
A standardscreeningprocedureusing the individualcut
approachhas the following steps:
(1) Collect and compute the values of X, and X2.
(2) An applicant is accepted if xl>k, and x2>k2, and
otherwiseis rejected.The acceptancerate is given by
= P[XI > kl, X2 > k2] (3)
Pl

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838 Journal
oftheOperational
Research Vol.56, No.7
Society

Selected Selected
region Sregion

x = k2

X2

C
alxl+a2X2=
\

X x =
k1
X, X,

Figure1 An individualcut approachof screening. Figure2 A linearcut approachof screening.

and its parametersat, a2 and the variance of error term e

(3) An applicantwho has been acceptedwill be are given, respectively,as
(i) bad, if y > ky; Poi - Po2P12
(ii) good, if y < k,. 1 - P2p12
In this screeningprocedure,the overall default rate after P02 - P0IP12
2 1--2 12 (7)
screeningis given by
2 =
1 + 2PolPo2Pl2 - Pl 02 P12
ae 1
qrl=-P[Y> klXI >kl, X2 >k2] (4) 2

Therefore, the object is to determine the optimal cutoff
points of xl >kl and x2 > k2 so that the overall default
rate afterscreeningis minimized.Namely, an optimal(k1,k2)
satisfiesthe following nonlinearprogrammingproblem:
Minimize rl,
Subjectto f-I constant
Clearly,if h1is prespecified,then (5) turns out to be a single
parameterproblem.
(b) Multiple screening variables
The effect of prediction will be improved when the
number of screening variables is increased. Suppose
there are k screening variables available, (5) would turn
out to be a (k-1)-parameter problem that is more difficult
to solve.
Note that the conditionaldistributionof Y given X, = xl and
X2 - X2 is also normally distributedwith mean a xI + a2x2
and varianceUa (Graybill,16p 106).
Therefore,the objectis to determinean acceptanceregion
of alx1 + a2x2< c to minimize the overall default rate after
(5) screening. The screening procedure using the linear cut
approachhas the following steps:
(1) Collect and compute the values of X1 and X2.
(2) An applicantis accepted if alxl + a2x2 c, otherwiseis
rejected.The acceptancerate is
#2 - P[alXi + a2X2 <c] (8)
(3) An applicantwho has been acceptedwill be
(i) bad, if y > ky;
(ii) good, if y <k,

The overall default rate after screening in the above

Linear cut approach
screeningprocedureis given by
(a) Two screening variables
In the linear cut approach, a linear equation constructed i2 =P[Y>k,,alX1i + (9)
azX2 <<c]
by two or more predictive screening variables is used When /2 is prespecified,by Equation(8) we can easilyget the
to judge whether an applicant is accepted or not as in cutoff point
Figure 2.
Again. assume that (Y, X1, X2) have the standard (10)
trivariatenormal distributionwith a covariancematrix as c=-0-I'(zf2)/V
in (2) for k=2. If X1 and X2 screening variables are where D-'(.) denotes the standard inverse normal distri-
combined linearly to predict Y, this formulates a normal bution and v is the coefficient of multiple determination
regressionmodel such as such as
2
t)a, S++ a +
Y= a1X1 + a2X2 + e (6) a + 2ala2p
1- (11)
2aazP12--

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(b) Multiplescreeningvariables
Let X'-(XI, X2, ... ,Xk) be a random vector with k
screening variables, which can be used to predict a
performancevariable Y. Also assume that (Y, X1, X2, ...,
Xk) have a standard(k + 1)-dimensionmultivariatenormal
distributionwith the covariancematrix as in (2). Then the
conditional distribution of Y given X=x is a normal
distributionwith mean 12Z221xand variance
Let u= 12~2121, U laiXi, and
12 21X=a'X =C 1--12j22•21.
W U/- /. Then (Y, W) have a standardbivariatenormal
distributionwith the covariancematrix
Q-i
1 (12)Numerical example
Now, the problem has been reduced to the case of one
screeningvariableand v/i is called 'equivalencecorrelation'.
However, the equations of acceptance rate and overall
default rate after screeningare similarto (8) and (9) except
that the acceptanceregion is substitutedby
E••laiXic.
Economic screening model
In the previous section, the default rate is minimizedfor a
given acceptance rate f/. However, in many practical
situations, the company might be more interested in
maximizingthe total profit of a certainprojectwith/without
the constraintof p. Hence, an economic screeningmodel for
credit assessmentproblemsis proposed to incorporatewith
different screeningproceduresin this section. To facilitate
the presentationsome notations are definedbelow:
N: total numberof customers
r: averagenet revenueper non-defaultingperson
d: averageloss per defaultingperson
f/: acceptancerate
q: overall defaultingrate after screening
The total profit is equal to total net revenue minus the
total loss due to defaulting,namely,
7E= [r(l - q) - dq]/N = [r- (r + d)]lPN
Note in (13) that maximizingtotal profit is equivalent to
minimizingdefault rate only when # is prefixed. For the
individualcut approach,(13) is in a nonlinearform such that
a numericalmethod is requiredto solve for optimal cutoff
points (kl, k2, ...) by maximizing the total profit. The
subroutineE04JAF in Numerical Analysis Group (NAG)
Library can be applied directly. If / is prespecified, it
becomes a one parameter problem. For the linear cut
approachwithout any constraint,an optimalcutoff point c*
can be obtainedin a closed form by maximizing(13) namely
r+
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forcredit
model
H-TTsaieta/-Aneconomic problem839
assessment
The Proof of (14) can be found in the Appendix. If / is
prespecified,then (10) is the formula for obtaining the
cutoff point c*. Similarly,for the single screeningvariable
case the optimal cutoff point k* of the screeningvariable
X is given by
k*= + (15)
ky - Ip r_+d
V1
2-lr
where p is the simple correlation coefficient between X
and Y.
Now a numericalexample simulatedfrom the example in
O'Conner6is provided to illustratethe use of the proposed
model. A financialcompanyis promotinga loan programme
in which some better customers will be selected from
N-= 10000 applicantsand certain amount of credit will be
grantedto them. In this programme,a good customerwill
generate average net revenue of $1000 per person while a
defaulting person will cause an average loss of $5000 per
person. The company'sobject is to maximizetotal profit of
the programmeby selectingbettercustomers.
In order to assess the applicant's credit, the company
bought a creditscore and individualdefaultrecordfrom 'X'
credit bureau and treated it as a single variable.Experien-
tially, the income ratio, one of the applicationdata provided
by all applicants, was an additional potential predictive
variable.Hence, both the credit score (XI) and the income
ratio (X2) are jointly used as two screening variables to
predictthe default rate.
Let Y denote an unobservableperformancevariablethat
describesthe likelihood of a customer'sdefaulting.Suppose
thereis a cutoff limit k., a customerwith Y> k, will default,
while one with
Y<<k,
will not default.Furthermore,assume
that (Y, X1, X2) have a standard trivariate normal
distributionwith the covariance(or correlation)matrix
1 -0.6 -0.4
S- -0.6 1 0.1
(13) -0.4 0.1 1
where Poi -0.6, P02 --0.4, and Pl2 = 0.1. This matrix is
obtained from the two-dimensionalcross table in O'Conner
exampleusing the estimationmethod describedfor (2).
From the company'sexperiencethe overalldefault rate i
is assumedto be 20%, which means that 80% of customers
are good. That is, when p[Y>k,] = 0.2, we can obtain k,
=-1(1-0.2)= 0.84162. The company plans to select the
40% best customers least likely to default and give them
entireadvance,otherwiserejectingthem.Now, four different
screeningproceduresare compared for a fixed acceptance
rate / = 0.4 as shown below.
(a) Single screeningvariableX1 (the creditscore). From
(14) acceptanceratep[X1 > k]= 0.4, we can determinethe cutoff
840 Journal
oftheOperational
Research Vol.56, No.7
Society

=0.25335. Then, the overall default rate after

point k'1
screeningis
=p[Y>0.84162|X1 >0.25335]
qj1
=BvN( - 0.84162, - 0.25335, - 0.6)/(O(0.25335)=4.87%o
(b) Single screening variable X2 (the income ratio).
Similarly, from acceptance rate p[X2>k2]=0.4, we can
determinethe cutoff point k2= 0.25335. Then, the overall
default rate after screeningis
qr =p[Y>0.841621X2>0.25335]
=BvN(-0.84162, -0.25335, -0.4)/D(0.25335)
=9.62%.
(c) The individual cut approach using X1 and X2.: Given
/= 0.4, a numericalsearchwas used to solve Eq. (5) for (kl,
k2). Consequently, an optimal solution was obtained as
kl - 0.02 and k2= -0.80, and the overall default rate after
screening is equal to r1 4.09%. Thus, the overall default
= economic screening model, the ratio of r (average net
rate after screeningdecreasesfurtherby 0.78% after we add
the income ratio as an additional screeningvariable.
(d) The linear cut approach using X1 and X2: Since the
acceptancerate # is prespecified,the optimal cutoff point
c* can be directly computed by (7)-(10). We obtain
a1 -0.5657, a2 -0.3434, c*=-0.1749, the resulting
acceptanceregionbecomes -0.5657X1-0.3434X2 < -0.1749,
0.1749, and the overalldefaultrate afterscreeningis equal to
2.96%. This default rate is 1.03% less than that of an
2z=
individualcut approach.
(e) Economic screening model: Now suppose that the
company plans to select some better customers from
N= 10000 applicants and gives them credit, a good
customerwill generatean averagenet revenueof r = $1000
per person, while a defaultingperson will cause an average
loss of d= $5000 per person.
For an economic screeningmodel with a constraintof /,
Table 1 summarizesthe comparisonof the four procedures
given various acceptance rates from 0.1 to 0.9 with an
incrementof 0.1. Thereare indeed differentscreeningeffects
upon variousacceptancerates.The defaultrate tends toward
small values for all procedures when the acceptance rate
decreases, while the total profit decreases when the
acceptance rate goes to either end. The comparison of
default rate versus acceptance rate for four screening
procedures is shown in Figure 3, and the comparison of
total profit versus acceptance rate is shown in Figure 4.
When / = 0.9, at least 10%defaultingcustomersare selected
since only 80% of all customers(l-q = 0.8) are assumedto
be good, and consequentlythe total profit becomes small,
for example, it is -$360 400 if X2 is used alone. When fl is
small, the total profit is small since the total net revenueis
small and the small default rate plays no role. Although
lower default rate can be obtained by screeningout lower
acceptancerate, it accompanieslower total profit, too. In an
revenue per non-defaulting person) and d (average loss
per defaultingperson)are used as well as the acceptancerate
and default rate, to obtain an optimal solution in term
of total profit.
For the linearcut approachwith two screeningvariables,
by (14) we can obtain a maximal profit of $3 801400 with
c* = 0.1418, the acceptancerate # = 58.14% and the overall
default rate after screening 2= 5.77%. By relaxing the
constraintof f = 40%, the maximaltotal profitof $3 801400
increasesby 15.6% compared with $3 289 600. By (15), an
optimalsolutioncan be obtainedfor the screeningprocedure
with one screeningvariable. The optimal total profit has
significant improvement with a larger correlation. For

Table1 A comparisonof four proceduresfor variousacceptancerates(fl)

(1) X1 (2) X2 (3) XK-X2 individualcut (4) X -X2 linear cut

Acceptance Default Total Default Total Default Total Default Total

rate rate profit (103) rate profit (103) rate profit (103) rate profit (103)

0.1 0.0112 933.0 0.0485 709.2 0.0061 963.6 0.0035 979.1

0.2 0.0225 1730.1 0.0667 1199.1 0.0153 1816.0 0.0097 1883.3
0.3 0.0349 2371.2 0.0820 1523.6 0.0270 2514.4 0.0184 2669.3
0.4 0.0487 2831.2 0.0962 1691.2 0.0409 3018.8 0.0296 3289.6
*0.4552 0.1038 *1717.0
0.5 0.0642 3073.1 0.1100 1699.7 0.0571 3285.6 0.0437 3689.0
*0.5439 0.0651 *3314.9
*0.5449 0.0718 *3100.6
*0.5814 0.0577 *3801.4
0.6 0.0818 3056.2 0.1240 1534.9 0.0760 3263.6 0.0613 3794.9
0.7 0.1020 2716.0 0.1388 1172.5 0.0979 2887.4 0.0831 3510.6
0.8 0.1260 1954.1 0.1547 573.4 0.1237 2062.6 0.1106 2690.9
0.9 0.1558 586.5 0.1733 -360.4 0.1551 622.5 0.1466 1084.4
*Is the optimal solution for each screening procedure.

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 model
Tsaiet al-Aneconomic
H-T problem841
assessment
forcredit

example, the optimal total profit is $3 100600 with
Pol=-0.6 while it is $1717 000 with 02= -0.4. For the
individual cut approach with two screeningvariables, the
optimal total profitis equal to $3 314900, which is in second
position among the four screeningprocedures.Clearly, the
linear cut approachwith two screeningvariablesuniformly
outperformsthe other three proceduresin terms of default
rate and total profit, and it has less computational
complexitythan the individualcut approach.

a Xl X1-X2 linear cut

----- X2 -- X1-X2 individual cut -'-
0.2 Impact of correlation between screening variables
Under the multivariatenormalityassumption,the screening
p 0.15 effect of using the above two screening variables was
0.1 influenced by the correlations among performance and
screeningvariables.The correlationbetweenthe two screening
S0.05 variableshas significantimpact on the linear cut approach.
The constraintintervalof P12must be subjectto the fact that
0 0.4 0.6
0.2 0.8 1 the covariancematrixI is positivedefinite,that is
rate
acceptance
P01P02 - 0 < P12 < P01P02
+ 0, where0
Figure3 Comparisonof defaultrateversusacceptanceratefor
four screeningprocedures.
(1- p,)(1 - p2 (16)

SX1 X2 -.- X1-X2 individual cut --- X1-X2 linear cut

In the previous example, we can obtain a range of
4 -0.4932<p12<0.9732, given that Pol = -0.6 and
P02 =-0.4. Using the same economic screening model,
Table 2 shows the screening effects of acceptance rate,
2 .
default rate and total profit for two approaches given
0 various values of P12. Clearly, the linear cut approach
0
uniformly outperforms the individual cut approach in
-1 terms of default rate, total profit, and computation
-2 complexity.
0 0.4 0.2 0.6 0.8 1 The equivalent correlation v in the second column
acceptancerate presents the power of prediction. It tends to large values
Figure4 Comparisonof totalprofitversusacceptanceratefor when P12 moves toward either end of the constraint interval,
four screening procedures. for example, i, = 1 when P12 = -0.4932 or 0.9732. Table 2

Table 2 Screening effects for various correlation P12 given po = -0.6 and p02 =-0.4
(1) X1-X2 individualcut (2) X1-X2 linear cut

Equivalent Acceptance Default Total Acceptance Default Total

P12 correlation rate rate profit (103) rate rate profit (103)
-0.4932 1 0.5119 0.0231 4410.6 0.8000 0.0000 8000.0
-0.4 0.9207 0.5326 0.0382 4104.2 0.6929 0.0203 6083.3
-0.3 0.8542 0.5392 0.0471 3867.4 0.6541 0.0317 5295.9
-0.2 0.8010 0.5420 0.0534 3684.4 0.6284 0.0403 4763.9
-0.1 0.7575 0.5433 0.0582 3536.5 0.6092 0.0472 4366.1
0 0.7211 0.5438 0.0620 3414.9 0.5939 0.0529 4053.7
0.1 0.6905 0.5439 0.0651 3314.9 0.5814 0.0577 3801.4
0.2 0.6646 0.5439 0.0676 3234.2 0.5709 0.0617 3594.6
0.3 0.6427 0.5440 0.0695 3172.0 0.5621 0.0651 3424.8
0.4 0.6249 0.5443 0.0709 3129.0 0.5549 0.0679 3287.7
0.5 0.6110 0.5447 0.0717 3106.2 0.5494 0.0701 3183.1
0.6 0.6021 0.5449 0.0718 3101.0 0.5457 0.0715 3116.4
0.6667 0.6000 0.5449 0.0718 3101.0 0.5449 0.0718 3101.0
0.7 0.6007 0.5449 0.0718 3101.0 0.5452 0.0717 3105.8
0.8 0.6142 0.5449 0.0718 3101.0 0.5508 0.0695 3210.4
0.9 0.6806 0.5449 0.0718 3101.0 0.5774 0.0592 3721.4
0.9732 1 0.5449 0.0718 3101.0 0.8000 0.0000 8000.0

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842 Journal
oftheOperational
Research Vol.56, No.7
Society
also showed that the total profit increasesas the equivalent
correlationincreasesfor the linear cut approach,while it is
not true for the individualcut approach.For example,when
V/ = 1 the linearcut approachcan exactlyidentifyall good
customers(80%)with zero defaultrate and consequentlythe
total profit is equal to $8 000 000. The individual cut
approach has two cases of /i = 1. When P12=0.9732, it
can only select 54.49%of customerswith 0.0718 defaultrate
and total profit of $3 101000; when P12= -0.4932, it can
only select 51.19%of customerswith 0.0231 defaultrate and
total profit of $4 410 600. Clearly, for large equivalence
correlations,the individualcut approachcannot improvethe
screeningeffect as much as the linearcut approachcan.
Furthermore,as the equivalent correlation is 0.6 when
P12 = 0.6667 (Pol/PO2 or P02/P01), it means that two screening
variableshave the same screeningeffect as only one of the
two screeningvariables;the two approacheshave exactlythe
same screeningeffects, since both have the total profit of
$3 101000.
Conclusions
For some financialcompanies, it is necessaryto collect all
possible personal information such as credit scorecards,
bureaudata, applicationdata, etc. for assessingapplicant's
credit. Although a credit scorecard normally consists of
multiple variables, it is treated as a single variable in real
application.How to combine all available information on
hand for selecting the better applicants is the issue with
which we are really concerned in this article. Under the
normality assumption, the screening procedures using
individual and linear cut approaches were proposed to
controldefaultrates.The linearcut approachcould easilybe
extended to the case with multiple screeningvariables,and
its optimal solution is in a closed form (see (14)).
Furthermore,an economic screeningmodel based on default
rate was proposed to incorporatewith individual cut and
linear cut approaches so that optimal cutoff points are
determinedby maximizingtotal profit.
An example with two predictivescreeningvariablesin a
loan programmeillustratedthe use of the proposedeconomic
screening model. We are interested in investigating the
followingfour screeningprocedures-using X1, X2, (X1, X2)
by individual cut approach, and (X1, X2) by linear cut
approach, respectively.The screeningeffects of these four
screeningprocedureswere compared in Table 1, and the
resultsshowed that the screeningprocedureusing the linear
cut approachuniformlyoutperformsthe others in terms of
defaultrate,total profitand computationcomplexity(Figures
3 and 4). Although lower default rate can be obtained by
screeningout lower acceptancerate, it accompanieslower
total profit, too. The proposed economic screeningmodel
could balanceboth acceptancerate and defaultrateto obtain
an optimal solution in term of total profit.
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The impactof correlationbetweentwo screeningvariables
is also examinedin Table 2. When the correlationis at either
end of the constraint interval, the total profit reaches the
largestvalue for the linearcut approach,while it is relatively
small for the individual cut approach. Therefore, the
screeningprocedureusing the linearcut approachis strongly
recommendedfor credit assessmentproblems.
A commercial scorecard is normally constructed using
severalvariablesand is costly, and here we do not intend to
discussits development,revision, or maintenance.However,
when more useful predictivevariables are considered,and
the originaldata of all variablesin the existing scorecardare
available, then the linear cut approach could serve as one
possible method to update the existing scorecard.For the
mailing credit assessment problem, the individual cut
approach was adopted by Tsai and Yeh14 instead of the
matrix approachused in Bennett et al.7 In future research,
the linearcut approachcould be applied and be expectedto
lead to significantimprovement.
Acknowledgements-Theresearch was supportedby the National
ScienceCouncil,Republicof China,underGrantNo. 89-2416-H-i110-
028 to the National Sun Yat-Sen University,Kaohsiung,Taiwan,
ROC.
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 model
Tsaiet a/-Aneconomic
H-T forcredit problem843
assessment

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x -k( (A3)
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-k+
(A4)
Appendix: Proof of (14) (~-)
Referringto Owen,17 one of the resultsis settingOci/c equal to zero. Consequently,the optimalcutoff
point of acceptanceregion is given by
I(x)( dx = BvN(h, k;p) (Al)
f px + v-V- (A5)
c* k' (r +d)
where D(.) denotes the standard normal distribution The second derivativecan be shown that
function, and BvN denotes the standard bivariate normal
distributionfunction. 02' cE-k7 '( ' + c
<0
(r +d)N (A6)
Rearrange(13), the total profit is C2-
-

Nrf2 - N(r + d)q2fl2

=Nr which indicatesthat c* is the optimal solution to maximize
the total profit71.

Received May 2004;

Nr( + (A2)
accepted September2004
c)--N(r d)BvN-( -k•,Vv),

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