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Credit scoring model

Batchu Satish

What is credit scoring?

Credit scoring can be formally defined as a statistical

method that is used to predict the probability that a loan
applicant or existing borrower will default or become
It is a systematic method for evaluating credit risk that
provides a consistent analysis of the factors that have been
determined to cause or affect the level of risk.
The objective of credit scoring is to help credit providers
quantify and manage the financial risk involved in
providing credit so that they can make better lending
decisions quickly and more objectively.

Credit scoring

Credit scoring was primarily dedicated to assessing

individuals who were granted loans, both existing and new
Credit analysts, based on pre-determined scores, reviewed
customers credit history and creditworthiness to minimize
the probability of delinquency and default.
Credit scoring process includes collecting, analyzing and
classifying different credit elements or variable to assess
the credit decision.
Some times credit score will help us to identify the
corporate bankruptcy.

Variables included to Build credit


Payment History
Making late payments, defaulting EMI s or dues shows trouble and
will give negative affect to the score

High utilization of credit limits

Increase current balance of credit limit is affect the credit score

Higher percentage of unsecured loans

instead have unsecured loans, having both secured and unsecured
loans will show positive affect for credit score.

Many new accounts opened recently

Having multiple loans and credit cards will increase the debt burden and it
negatively impact on credit score.

Proportion of variable in credit





payment history

Credit limit

Types of loans

new credit

Performance chart to Identify cut-off


Credit scoring Models life cycle

A standard life cycle model for credit scoring designed on

the basis of A-IRB approach(BASEL II capital requirement)
Life cycle of any model is defined three phases i.e.
assessment, implementation and validation.
Model assessment
In order to develop credit scoring model we need past
behavior of client data, so that we can assess the
Probability of default or non-default.
If past details of client and sufficient data is available we
go for empirical model, it is used for existing clients.
If past data is not available, new client, an expert or
generic model is suitable for solution.

Model Implementation

It allows the banks to implement automated decision system

to manage their retail client
In implemented process the main task for credit manager is
to define most appropriate and efficient threshold/ cut-off to
credit model
To maximize the benefit of scoring model, cut-off should be
set taking into account of all misclassification accounts of
Type-I and Type-II errors.

Model validation

Back testing and benchmarking are two important aspects in

scoring model validation.
With the back testing credit analyst identify the calibration
and discrimination of scoring model.
Benchmarking is another quantitative validation method
which aims at assessing the consistency of the estimated
scoring models with those obtained using other estimation
techniques, and potentially using other data sources.
This analysis maybe quite difficult to perform for retail
portfolios given the lack of generic benchmarks in the

Development of credit scoring

models over a period of time


Logistic regression
and probit analysis*

1971 onwards

Decision tree and


From 1994

Neural Networks**

From 1995

From 1994
* Traditional or conventional statistical method
** Advanced computerized methodologies

Normality restriction
It mostly deals with
categorical/ qualitative
value thus It does not
require Normality
The accuracy of above two
models was not very high.
With high implementation
of machine these models
are exhibited as well as
accuracy was high

Conceptual framework for credit


For Individual;

Individual Borrowers

With use of some methods we

can assess the cut-off as well as compVariable consider for
re with different methods and then credit
Time at present
identify the best cut-off.
Include some
parameters which
can improve the
of loan



Private/public sector
Time at current
Monthly revenues
House owner
No previous credits
Duration of the loan
Amount and type of

And other

Conceptual framework for credit scoring

For corporate clients;
Corporate clients
This method is useful to identify the bankruptcy
Level of corporate client(SMEs).

Reject the application


Identify the
Bankruptcy level with
using Z-score

Identify the Ratios which

tells about financial
position of client
Liquidity ratios
Profitability ratios
Solvency Ratios
Working capital
Leverage ratios
Turn over Ratios
Promoter efficiency
in corporation

Sample size and methodology to

Build a credit scoring

It is very important to determine the sample size before the

model build
The more sample consideration, the more accuracy can
For individuals; it is more important to incorporate the
variable like behavioral, economic to estimation of
probability of default(PD).
For corporate(SMEs); financial ration will help to predict
the financial and asset position of the client.

Rationale for credit score

For individuals;
credit score be one of the most important factors in
determining whether or not you are approved for credit.
it also be a major factor in determining the terms and
conditions of the loan/credit extension.
It can help to understand the interest rate structure for loan
low credit score= high interest (vice-versa)
For corporate clients:
It useful to determine the bankruptcy position of firm.
For Banks and financial institutions:
It is very helpful to predict the customer default position with cut-off
score, also good or Bad 'customer.

wrap-up & remarks

Over a period of time many credit scoring models are exhibited

to identify the default/ non-default position for customer.
Paradigm shift has taken in credit scoring models from
Traditional statistical to modern methods but these method
couldnt incorporate the important situations such as behavioral,
errors of credit scoring and macro economic conditions.
It is the big gap for both financial institutions as well as
Also some technical issues will be make customers as default.
When creating and building a credit scoring models
incorporating those variable which have been left over the period
of time will give better fit model. This will improve the
profitability and decrease the customer default position