Credit Risk Scoring Models

Abstract

Credit scoring models play a fundamental role in the risk management practice at most banks. They are used to quantify credit risk at counterparty or transaction level in the different phases of the credit cycle (e.g. application, behavioural, collection models). The credit score empowers users to make quick decisions or even to automate decisions and this is extremely desirable when banks are dealing with large volumes of clients and relatively small margin of profits at individual transaction level (i.e. consumer lending, but increasingly also small business lending). In this article, we analyze the history and new developments related to credit scoring models. We find that with the new Basel Capital Accord, credit scoring models have been remotivated and given unprecedented significance. Banks, in particular, and most financial institutions worldwide, have either recently developed or modified existing internal credit risk models to conform with the new rules and best practices recently updated in the market. Moreover, we analyze the key steps of the credit scoring model’s lifecycle (i.e. assessment, implementation, validation) highlighting the main requirement imposed by Basel II. We conclude that banks that are going to implement the most advanced approach to calculate their capital requirements under Basel II will need to increase their attention and consideration of credit scoring models in the next future.

Keywords: Credit scoring models, Basel II, Retail banking, Model lifecycle, Risk management, Model assessment, Model implementation, Model validation

JEL Classification: G17, G21