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Statistical Classification Methods in Consumer Credit Scoring a Review

Statistical Classification Methods in Consumer Credit Scoring a Review

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StatisticalClassificationMethodsinConsumerCreditScoring:AReview
STOR
D.
J.
Hand,W.
E.
Henley
JournaloftheRoyalStatisticalSociety.SeriesA(StatisticsinSociety),
Volume160,Issue3(1997),523-541.
StableURL:http://links.jstor.org/sici?sici=0964-1998%281997%29160%3A3%3C523%3ASCMICC%3E2.0.CO%3B2-2YouruseoftheJSTORarchiveindicatesyouracceptanceofJSTOR'sTermsandConditionsofUse,availableathttp://www.jstor.org/aboutiterms.html.JSTOR'sTermsandConditionsofUseprovides,inpart,thatunlessyouhaveobtainedpriorpermission,youmaynotdownloadanentireissueofajoumalormultiplecopiesofarticles,andyoumayusecontentintheJSTORarchiveonlyforyourpersonal,non-commercialuse.EachcopyofanypartofaJSTORtransmissionmustcontainthesamecopyrightnoticethatappearsonthescreenorprintedpageofsuchtransmission.
JournaloftheRoyalStatisticalSociety.SeriesA(StatisticsinSociety)
ispublishedbyRoyalStatisticalSociety.Pleasecontactthepublisherforfurtherpermissionsregardingtheuseofthiswork.Publishercontactinformationmaybeobtainedathttp://www.jstor.org/joumals/rss.html.
JournaloftheRoyalStatisticalSociety.SeriesA(StatisticsinSociety)
©1997RoyalStatisticalSocietyJSTORandtheJSTORlogoaretrademarksofJSTOR,andareRegisteredintheU.S.PatentandTrademarkOffice.FormoreinformationonJSTORcontactjstor-info@umich.edu.©2002JSTORhttp://www.jstor.org/WedMay1517:55:262002
 
1.R.Statist.Soc.
A(1997)
160,Part
3,
pp.523-541
StatisticalClassificationMethodsinConsumerCreditScoring:aReview
ByD.
J.
HANDtandW.E.HENLEY
TheOpenUniversity,MiltonKeynes,UKRothschilds,London,UK
[ReceivedMarch1995.FinalrevisionOctober1996]SUMMARY
Creditscoringisthetermusedtodescribeformalstatisticalmethodsusedforclassifyingapplicantsforcreditinto'good'and'bad'riskclasses.Suchmethodshavebecomein-creasinglyimportantwiththedramaticgrowthinconsumercreditinrecentyears.Awiderangeofstatisticalmethodshasbeenapplied,thoughtheliteratureavailabletothepublicislimitedforreasonsofcommercialconfidentiality.Particularproblemsarisinginthecreditscoringcontextareexaminedandthestatisticalmethodswhichhavebeenappliedarereviewed.
Keywords:
CLASSIFICATION;CONSUMERLOANS;CREDITCONTROL;CREDITSCORING;DISCRIMINANTANALYSIS;FINANCE;REJECTINFERENCE;RISKASSESSMENT
1.
INTRODUCTION
Inthispaperweusetheterm'credit'torefertoanamountofmoneythatisloanedtoaconsumerbyafinancialinstitutionandwhichmustberepaid,withinterest,ininstalments(usuallyatregularintervals).Wefocuschieflyonmethodsforclassifyinganapplicantforcreditintoclassesaccordingtotheirlikelyrepaymentbehaviour(e.g.'default'or'notdefault'withrepayments),butweshallalsobrieflyconsiderotherassociatedproblemsinthecreditindustry.Theprobabilitythatanapplicantwilldefaultmustbeestimatedfrominformationabouttheapplicantprovidedatthetimeoftheapplication,andtheestimatewillserveasthebasisforanacceptorrejectdecision.Accurateclassificationisofbenefitbothtothecreditor(intermsofincreasedprofitorreducedloss)andtotheapplicant(avoidingovercommitment).Thisactivity-decidingwhetherornottograntcredit-iscarriedoutbybanks,buildingsocieties,retailers,mailordercompanies,utilitiesandvariousotheror-ganizations.
It
isaneconomicactivitywhichhasseenrapidgrowthoverthelast30years.Somefigureswillillustratethesizeoftheconsumercreditindustry.ThetotalUKconsumerdebt,includingmortgages,bankloans,debtstoretailers,creditcarddebts,etc.,isabout£500billion.In1994intheUKabout12%ofretailexpenditurewasmadeusingcreditcards,amountingtoatotalofabout£36billion.Creditcardspendingincreasedbyabout16%betweenJanuary1995andJanuary1996.Around10millionBritishhouseholdscurrentlyhavemortgages.Traditionalmethodsofdecidingwhethertograntcredittoaparticularindividualusehumanjudgmentoftheriskofdefault,basedonexperienceofpreviousdecisions.However,economicpressuresresultingfromincreaseddemandforcredit,alliedwith
+Addressforcorrespondence:
DepartmentofStatistics,FacultyofMathematicsandComputing,TheOpenUniversity,WaltonHall,MiltonKeynes,MK76AA,UK.E-mail:d.j.hand@open.ac.uk
©
1997RoyalStatisticalSociety0964-1998/97/160523
 
524
HANDANDHENLEY
[Part.3,
greatercommercialcompetitionandtheemergenceofnewcomputertechnology,haveledtothedevelopmentofsophisticatedstatisticalmodelstoaidthecreditgrantingdecision.
Creditscoring
isthenameusedtodescribethismoreformalprocessofdetermininghowlikelyapplicantsaretodefaultwiththeirrepayments.(Sometimestheterm
applicationscoring
isusedtodistinguishitfrom
behavioural
or
performancescoring,
whichreferstomonitoringandpredictingtherepaymentbehaviourofaconsumertowhomcredithasalreadybeengranted.)Statisticalmod-els,called
score-cards
or
classifiers,
usepredictorvariablesfromapplicationformsandothersourcestoyieldestimatesoftheprobabilitiesofdefaulting.Anacceptorrejectdecisionistakenbycomparingtheestimatedprobabilityofdefaultingwithasuitablethreshold.Standardstatisticalmethodsusedintheindustryfordevelopingscore-cardsarediscriminantanalysis,linearregression,logisticregres-sionanddecisiontrees.Intheindustry,thepredictorvariablesaretypicallycalled
characteristics,
aterminologywhichweshallretainhere.Thevaluesthattheycantakearecalled
attributes.
Loansmaybefixedterm-therepaymentcalculationsaresuchthattheloanandinterestwillbetotallyrepaidafteracertaintime-ortheymaybe
rolling
or
revolving
loans,suchaswithcreditcards,wheretheloanamountcanbeincreasedflexibly.Thelengthofafixedtermloanrepaymentperiodwill,ofcourse,dependonthenatureoftheloan.Amortgagemaybeovera25-yearperiod,whereasacarloanwillbeforamuchshorterperiod,andtherepaymentperiodforcataloguepurchasesshorterstill.Onemightbeinterestedintheprobabilitythattheborrowerwillhavedefaultedbytheendoftheloanperiodorinmoresubtlemeasures,suchastheprobabilitythattheyaretwoorthreepaymentsbehindattheendof1year.Onecomplicationisthatthepopulationofpotentialborrowersevolvesowingtoselectionprocesses.Hand
etal.
(1996a)havedescribedhowaninitialpopulationgoesthroughvariousselectionsteps:thebankdecidestowhomtomailanapplicationform;onlysomeofthesereturntheform;thebankscorestheseandofferssomealoan;onlysomeoftheseaccepttheloan;ofthesesomedefaultandsomerepayearly;andfinallythebankdecidestowhomtoofferafurtherloan.Thedatafromwhichascore-cardwillbeconstructedwillbethatina
(design)
sampleofapplicantstowhomcredithasalreadybeengranted.Normallythiswillincludethevaluesoftheircharacteristics(whichherewetaketoincludeinformationfrom
creditbureaux-see
Section2)andalsothetrueclass(which,forbrevity,weshallherecall'good'or'bad'riskclasses)towhichtheywerefoundtobelong.Thus,implicitinalltheworkthatwediscussinthispaper,wemakeastraightforwarddivisionofapplicantsintotwogroups.Moresophisticatedapproachescancategorizethedesignsampleapplicantsona(possiblymultidimensional)continuumaccordingtotheirrepaymentbehaviour,andthismorerefinedscalecanbeusedastheresponsevariable(s)inthemodel.Similarly,thefactthatpeoplearesubjecttoinfluenceswhichcanchangetheirpropensitytodefault(externalsocialorfinancialpressures,forexample)willalsonotbediscussedhere;suchthingscouldbeintegratedintoabehaviouralscoringmodel.Indeed,althoughdefaultriskisthefocusofthegreaterpartofcreditscoringeffortintheindustry,onecanarguethatthisriskisonlyoneaspectoftheoverallcreditgrantingdecision.Themainaimwillnormallybetomaximizeprofits,andprofitabilityneednotbemonotonicallyrelatedtorisk.Forexample,verylowriskapplicantswhopayofftheircreditcardbilleachmonth,sothatthelendercannotchargeinterest,arenotprofitable.Conversely,veryhighrisk

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