Chapter Three

Credit scoring techniques

12/13/21 978-0-7346-1164-2 1
Learning objectives

1. Explain the practical use of a credit scorecard

2. Summarise the history of credit scoring
3. Explain the growth in consumer credit
4. Discuss why retail credit scoring has become so important
5. Explain the process of building a credit application
scorecard
6. Discuss the 4 R’s of credit scoring
7. Discuss how credit scoring might evolve in the future
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Introduction

• Credit scoring uses statistical analysis to determine the

probable repayments of debts by consumers. A score is
assigned to an individual based on information
processed from a number of sources
• It has revolutionised the granting of credit generally and
consumer credit in particular
• An example of a credit application scorecard is covered
• And also how to build a credit application scorecard
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An example of a credit
application scorecard

• A credit scorecard from the Home Loan Experts website

• Suggested by HLE for use by prospective home loan
borrowers to generate a realistic credit score
• 12 questions in total
• The higher the score the lower the creditworthiness of the
prospective borrower
• Refer to “Industry Insight” section for a detailed coverage of
the scorecard
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• The key scoring factors in the credit scorecard
• Bankrupt = 100 points
• Discharged bankrupt = 50 points
• Loan-to-valuation ratio greater than 95% = 50 points
• Liabilities more than assets = 40 points
• More than 6 credit enquiries = 30 points
• Missed debt repayments in last 6 months = 25 points
• Borrowing more than $1m = 25 points
• No genuine savings = 20 points
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Using the credit scorecard

• The worst possible borrower score = 328 points

• The best possible borrower score = -10 points
• Scores up to 35 points are classified as “low risk”
• Scores between 35 and 55 points are “medium risk”
• Scores above 55 points are classified as “high risk”
• These cutoff scores can be changed by the lender

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History of credit scoring

• The average adult in the US is currently being credit

scored once per week either on new or existing accounts
• Three phases of in the history of credit scoring:
• 1935 – 1959 Pioneers
• 1960 – 1979 The Age of Automation
• 1980 + The Age of Expansion

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Growth in consumer credit

• The link between the Global Financial Crisis (GFC) and the
use of credit scoring in consumer credit
• 58% of bank lending in Australia is consumer credit
• Probably all credit card applications in Australia are credit
scored
• Probably most housing loan applications are also credit
scored
• Credit providers in Australia (since July 2012) can no longer
send unsolicited invitations to customers
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Why has retail credit scoring
become so important?

• The choice between judgemental credit decisions versus

credit scoring
• The move from relationship management to transactional
lending
• The desire of banks to reduce costs and increase accuracy
of lending decisions

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How to build a credit
application scorecard

• Credit application scorecards are the main type of scorecard

• Other types:
• Behavioural scoring
• Collections scoring
• Customer score
• Bureau score

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The overall goal

• Collect historical information on all individuals who applied for credit over a 1
year period
• Usually start with 50 explanatory variables
• These are usually reduced to around 10 variables
• The dependent variable is the borrower’s performance in the first year (“Good”
– less than 3 months of missed payments; “Bad” – more than 3 months of
missed payments
• Note that 3 months corresponds with APRA’s impaired asset definition
• Unsuccessful applicants are usually included in this analysis
• Usually 1m+ applicants in a data set for a larger bank 11
Other considerations

• Data sample
• Data validation and cleaning
• Data segmentation
• Development sample and validation sample
• Reducing the number of variables in the model
• Coarse classifying characteristics
• Regression analysis

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Moving beyond credit
application scorecards

• The 4 R’s of credit scoring

• Risk
• Response
• Retention
• Revenue
• The apparent link between insurance fraud and credit
default
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The future of credit scoring

• Building better credit scoring models

• Incorporating economics and market conditions into
credit scoring models
• Credit scoring models for Basel II

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