Credit Risk Scorecards Developing and Implementing Intelligent Credit Scoring Naeem Siddiqi John Wiley & Sons, Inc.
Additional praise for Credit Risk Scorecards... An essential book for anyone interested in retail credit risk modeling. Written by an experienced credit scoring practitioner, it provides a unique and comprehensive insight into the scorecard development process. NOR ZIHAN ISMAIL, Credit Risk Analytics Specialist, Malaysian leading bank
Credit Risk Scorecards Developing and Implementing Intelligent Credit Scoring Naeem Siddiqi John Wiley & Sons, Inc.
This book is printed on acid-free paper. Copyright 2006 by SAS Institute Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978 750 8400, fax 978 646 8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201 748 6011, fax 201 748 6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800 762 2974, outside the United States at 317 572 3993 or fax 317 572 4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at http://www.wiley.com. SAS and all other SAS Institute Inc. product or service names are registered trademarks or trademarks of SAS Institute Inc. in the USA and other countries. (r) indicates USA registration. Library of Congress Cataloging-in-Publication Data: Siddiqi, Naeem, 1969 Credit risk scorecards: developing and implementing intelligent credit scoring / Naeem Siddiqi. p. cm. Includes bibliographical references and index. ISBN-13: 978 0-471 75451 0 (cloth) ISBN-10: 0 471 75451-X (cloth) 1. Credit scoring systems. 2. Risk management. I. Title. HG3751.5.S53 2006 658.8'8 dc22 2005017415 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1
To Noor and Zainab, for giving me unparalleled joy.
Contents Acknowledgments ix chapter 1 Introduction 1 Scorecards: General Overview 5 chapter 2 Scorecard Development: The People and the Process 11 Scorecard Development Roles 11 Scorecard Developer 11 Product or Portfolio Risk Manager/Credit Scoring Manager 12 Product Manager(s) 13 Operational Manager(s) 13 Project Manager 14 IT/IS Managers 15 Enterprise Risk/Corporate Risk Management Staff (Where Applicable) 15 Legal Staff 16 Intelligent Scorecard Development 16 Scorecard Development and Implementation Process: Overview 17 chapter 3 Scorecard Development Process, Stage 1: Preliminaries and Planning 21 Create Business Plan 21 Identify Organizational Objectives and Scorecard Role 21 Internal versus External Development and Scorecard Type 23 Create Project Plan 24 Identify Project Risks 25 Identify Project Team 25 Why Scorecard Format? 26 vii
viii contents chapter 4 Scorecard Development Process, Stage 2: Data Review and Project Parameters 29 Data Availability and Quality 29 Data Gathering for Definition of Project Parameters 30 Definition of Project Parameters 31 Exclusions 31 Performance and Sample Windows and Bad Definition 32 Effects of Seasonality 37 Definition of Bad 38 Confirming the Bad Definition 40 Good and Indeterminate 43 Segmentation 45 Experience-Based (Heuristic) Segmentation 47 Statistically-Based Segmentation 50 Comparing Improvement 53 Choosing Segments 55 Methodology 56 Review of Implementation Plan 57 chapter 5 Scorecard Development Process, Stage 3: Development Database Creation 59 Development Sample Specification 59 Selection of Characteristics 60 Sampling 63 Development/Validation 63 Good/Bad/Reject 63 Development Data Collection and Construction 65 Random and Representative 65 Nonsegmented Dataset 65 Data Quirks 66 Adjusting for Prior Probabilities 66 Offset Method 68 Sampling Weights 69 chapter 6 Scorecard Development Process, Stage 4: Scorecard Development 73 Explore Data 74 Missing Values and Outliers 74 Correlation 76 Initial Characteristic Analysis 77 Statistical Measures 79 Logical Trend 83 Business/Operational Considerations 87
contents ix Preliminary Scorecard 88 Risk Profile Concept 88 Logistic Regression 89 Designing a Scorecard 92 Reject Inference 98 Reasons for Reject Inference 99 Reject Inference Techniques 102 Verification 112 Final Scorecard Production 113 Scaling 113 Points Allocation 118 Choosing a Scorecard 119 Misclassification 120 Scorecard Strength 121 Validation 127 chapter 7 Scorecard Development Process, Stage 5: Scorecard Management Reports 131 Gains Table 132 Characteristic Reports 133 chapter 8 Scorecard Development Process, Stage 6: Scorecard Implementation 135 Preimplementation Validation 135 System Stability Report 136 Characteristic Analysis Report 139 What if the Scorecard Does Not Validate? 141 Strategy Development 142 General Considerations 142 Scoring Strategy 143 Setting Cutoffs 146 Strategy Development Communication 151 Risk-Adjusted Actions 154 Policy Rules 157 Overrides 158 chapter 9 Scorecard Development Process, Stage 7: Postimplementation 161 Scorecard and Portfolio Monitoring Reports 161 Scorecard Management Reports 164 Portfolio Performance Reports 177 Review 187 Bibliography 189 Index 191
Acknowledgments Writing a good book, like developing a good scorecard, is never a one-person show. I would like to express my gratitude to a few people who have supported me in this endeavor. I would like to thank: Dr. David Yeo, Hendrik Wagner, and Clark Abrahams of SAS, for their invaluable suggestions on, and contributions to, the content of this book. Lorne Rothman and John Amrhein of SAS Canada for helping to enhance my knowledge of data mining. Stephenie Joyner of SAS Publishing, for her patience and perseverance. I want to thank my family Saleha, Zainab, and Noor for tolerating my frequent absences from home, and the hours spent in my office working on the book. Finally I want to acknowledge my parents for encouraging me to seek knowledge, and for their constant prayers and blessings, without which there would be no success. xi
chapter 1 Introduction Increased competition and growing pressures for revenue generation have led credit-granting and other financial 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 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 now 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 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. In the insurance sector, the ability to keep the prices of policies commensurate with claims risk becomes more critical as underwriting losses increase across the industry. 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 deal with them effectively to minimize further loss and recoup any monies owed, as quickly as possible. 1