Scoring Systems

Chapter 16


EXAMPLE: CREDIT CARD
APPLICATION
Chapter 16 Scoring Systems 1
Chapter 16 Scoring Systems
EXAMPLE: CREDIT CARD
APPLICATION
2
Description
Mathematical methods (scoring systems)
Customer selection
Allocate resources among customers
Purposes
Replace individual judgment with a cheaper and
more reliable method
Augment individual judgment by variable
reduction

Chapter 16 Scoring Systems
Introduction
3
Typically the decision is either accept
or reject, in other words a 0 or a 1
Separate existing customers into two
groups:
"good" and "bad
(Example: Customers who paid back a
loan vs customers who defaulted on a
loan)
Chapter 16 Scoring Systems
Method
4
Find variables associated with good/bad
results
Determine a simple numerical score that
identifies the risk (probability) of
good/bad results
Determine a risk cut-off level that
maximizes firm effectiveness
Customers over cut-off accepted, below
cut-off rejected

Chapter 16 Scoring Systems
Method
5
Customer solicitation
Lead generation for cold calls, list generation
for mailings reduces costs by eliminating
unlikely customers from list
Customer evaluation
Credit granting, school admissions
Resource allocation to customers
Live telephone call, automated call, letter,
Data reduction (Apgar, Apache medical
scores)
Simplifying information
Chapter 16 Scoring Systems
Relevance Uses of Scoring
6
Types of companies that use scoring
Retail Banks
Finance Houses
Loan approval for credit cards, auto loans, home loans,
small business loans
Solicitation for products (pre-approved credit cards)
Credit limit settings and extensions
Credit usage
Customer retention
Collection of bad debts
Merchant Banks
Corporate bankruptcy prediction from financial ratios
Utility Companies
Credit line establishment
Length of service provision
Chapter 16 Scoring Systems
Relevance - Breadth of Corporate Use
7
IRS
Income tax audits
Parole Boards
Paroling prisoners
Mass Mail/Telemarketing
Retailers
Target market identification (e.g., high incomes)
Selecting solicitation targets (response rate prediction)
Insurance
Auto/home who to accept/reject, level of premium credit
score as a predictor of auto accidents
Education
Accept/reject too good to go here financial aid as
enticement to attend
Chapter 16 Scoring Systems
Relevance - Breadth of Corporate Use
8
History of Scoring Systems
Developed in 1941 for use by Household
Finance Co. (HFC)
Acceptance by banks in the 1970s
Profitability
Equal Credit Opportunity Act (ECOA) and
Regulation B prohibited discrimination in lending
Discrimination could be proven statistically
Scoring was designed as a statistically sound,
empirically based system of granting credit
Explosion in the use of scoring in the
1980s/90s due to increased computational
ability
Chapter 16 Scoring Systems 9
Many models derived "in-house
U.S. firms
Fair, Isaac and Co. California
MDS Georgia
Mathtec - New Jersey
European firms
Scorelink
Scorex Ltd.
CCN Systems
Results
Bank credit cards: average reduction in ratio of bad
debts/total portfolio of 34%, need fewer lenders
Direct mail: cuts mailing costs 50% while cutting
response rate only 13%
The Market
Chapter 16 Scoring Systems 10
Example:
Profit from good account, $1; loss from a bad
account, $9
Approve 100 accounts each with odds of 95%
good
Profit = 95x$1 - 5x$9 = $50
Approve 100 accounts each with odds of 80%
good
Profit = 80x$1 - 20x$9 = -$100
Approve accounts until
Expected Profit = Expected Loss from marginal
account
Chapter 16 Scoring Systems
Methods
11
Example
P= Odds of good account
Expected Profit = Profit x P
Expected Loss = Loss x (1-P)
Profit x P = Loss x (1-P)
Profit x P = Loss - (Loss x P)
P = Loss / (Profit + Loss)
P=9/(9+1)=90%
Conclusion: need accurate assessment of
"odds"
Chapter 16 Scoring Systems
Methods
12
Numerical Risk Score
Example: direct mail costs $0.45 per
piece if it lands in the trash and an
average profit of $20 per positive
response, it would be profitable to send
mailings to those with a probability of 2.2%
or higher of responding
% 2 . 2
) 45 . 00 . 20 (
45 .
Bad of Cost Good of Profit
Bad of Cost
=
+
=
+
Chapter 16 Scoring Systems 13
Data Collection:
Dependent Variable: Separate historical
results into "good" and "bad" groups
(0,1) dependent variable
Independent Variables: Information from
appropriate sources (e.g., credit
application, purchasing behavior) that
may be associated with outcome
Expensive, time consuming in some
cases

Chapter 16 Scoring Systems 14
Usual procedure: divide all independent variables into (0,1)
variables
For example: If income < 25,000, then variable IN1 = 1, else
IN1 = 0
If 25,000 < income < 50,000, then variable IN2 = 1, else IN2
= 0, etc.
Income Inc<25 25<Inc<50 Inc>50
26,555 0 1 0
33,456 0 1 0
113,000 0 0 1
90,000 0 0 1
15,000 1 0 0
12,000 1 0 0
Chapter 16 Scoring Systems
Data Collection:
15
Modeling techniques that give "odds" of a
good/bad outcome
Multiple regression
Logistic regression - designed for (0,1) dependent
variable
Discriminant analysis - develops variable weights
for the maximum separation of the means of the
two groups
Recursive partitioning - repeatedly splitting into
two groups as alike as possible in terms of
independent variables, and as different as possible
in terms of the dependent variable
Nested regression or discriminant analysis - more
closely examines those "on the bubble"
Chapter 16 Scoring Systems
Models
16
Example: Profit $1, Loss $9, so P = .90
Rule: accept all accounts with score >.90
Regression: Dependent variable: 1 if good, 0
if bad
Y = B
0
+B
1
X
1
+B
2
X
2
...

.40 + .20 Own Home - .75 Other
+ .40 S+C w/bank +.25 S+C + .15 checking
+ .15 (56+yrs old) + .10 (36-55) + .05 (<25)
+ .15 Retired + .05 Mgr - .05 Laborer
+ .10 (10+ yrs job) + .05 (5-10 yrs)
Chapter 16 Scoring Systems
Credit Card Account Modeling
Multiple Regression Model
17
Probability of good account
Ann Bob Craig Dave Eileen Frank
1.30 .70 .85 .80 .80 -.20
Chapter 16 Scoring Systems
Credit Card Account Modeling
Multiple Regression Model
18
Paid = 1 * * * * * * *

Fitted Regression Line
Defaulted = 0 * ** * * * *

Chapter 16 Scoring Systems
Multiple Regression Fit of a Perfect
Data Set
Loan
Result
20 25 30 35 40 45 50
Age
19
Paid = 1 * * * * * * *

Fitted Regression Line
Defaulted =0 * ** * * * *

Chapter 16 Scoring Systems
Multiple Regression Fit of a Perfect
Data Set
Loan
Result
20 25 30 35 40 45 50
Age
20
Logistic Regression
Logisitic regression
fits the function:

Which becomes:
Determine the cutoff
score based on the
monetary
relationship between
good and bad
accounts
(

=
) 1 (
ln
odds
odds
score
) 1 ( +
=
score
score
e
e
odds
718 . 2 ~ e
Chapter 16 Scoring Systems 21
Scorecard Example
Calculate the cutoff score
Assume that the probability of a good account
would have to be 90% for approval
The cutoff score would be:
20 . 2
) 90 . 1 (
90 .
ln score cutoff =
(

=
Chapter 16 Scoring Systems 22
Scorecard Example
Logistic regression gives the following
equation:



Multiply all values X 100 for simplicity
yrs) 0.25(5to10 10yrs) 0.53( er) 0.26(labor - er) 0.25(manag
ed) 0.33(retir 5) 0.20(26to3 - 5) 0.15(36to5 56) .5(age
ing) 0.05(check - C) & (S 0.85 ) 0.05(other - home) own ( 3 . 1 8 . 0 score
+ > + +
+ + > +
+ + =
Chapter 16 Scoring Systems 23
Scorecard Example
Base a scorecard on the fitted equation:
Everyone starts with 80 points
Residence Own Home
+130
Other
-5
Bank
Accounts
Savings and Checking with bank
+85
Checking only
-5
Age 56+
+50
36-55
+15
26-35
-20
Work Retired
+33
Manager
+25
Laborer
-26
Time on Job 10 yrs or more
+53
5-10 yrs on job
+25
Chapter 16 Scoring Systems 24
Scorecard Example
A 65 year old retired homeowner with only
a checking account with the bank, who
worked for 8 years for his previous
employer would score:



Since 313>220, the loan would be
approved
313 25 33 50 5 130 80
(5to10yrs) retired 56 age checking own base
= + + + +
+ + > + +
Chapter 16 Scoring Systems 26
Other Scoring Models
Decision-Tree Score Cards
Follow a path based on demographic
characteristics until a branch ends in
acceptance or rejection
Chapter 16 Scoring Systems 27
Applicant
Own Home Rent Other than
rent or own
Probability of
good account
0.95 0.89 0.73
Decline
Acct w/ bank
No Account
with bank
0.99 0.92
Accept
Recursive Partitioning
Chapter 16 Scoring Systems 27
Analyzes customer behavior instead of
demographic characteristics
Example Bad Debt Collection
Costs (GE Capital 1990):
$12 billion portfolio
$1 billion delinquent balances
$150 million collection efforts
$400 million write-offs

Resources:
Letters (many types)
Interactive taped phone messages
(2 levels of severity)
Live phone calls from a collector
Legal procedures
Chapter 16 Scoring Systems
Behavioral Scoring
28
Daily Volume:
50,000 taped calls
30,000 live calls
Need for strategy:
Too expensive - actual costs and goodwill to
personally call each delinquent
Customers require different amounts of prodding to
pay
Results:
Scoring indicated that more customers should be
handled by "doing nothing
Scoring reduced losses by $37 million/year, using
fewer resources and with more customer goodwill
Chapter 16 Scoring Systems
Behavioral Scoring
29
Problems with Scoring Systems
Good vs. Bad doesnt take into account
underlying differences in customer
profitability
Screening bias
If certain demographics are not present in the
current customer base, theres no way to
judge them with a scoring system
Scoring systems are only valid as long as
the customer base remains the same
Update every three to five years
Chapter 16 Scoring Systems 30
Implementation Problems
Fairness
Scoring systems may lock out minorities
Manual overrides (exceptions) may favor non-
minority customers
Impersonal decision making
Federal Reserve governor denied a Toys R
Us credit card
Face Validity: Does the data make
sense?
Misuse/nonuse of score cards
Chapter 16 Scoring Systems 31
Using SPSS for Logistic Regression
on the MBA S&L case

Initial screen:
Open file from CD-ROM, chapter16_mbas&l_case_SPSS_format

On menu: Analyze, Regression, Binary Logistic

In the logistic regression menu:
good is the dependent variable
Choose independent variables as you see fit
Under options the classification cut-off is set at 0.5. Insert a cut-
off appropriate for the case data.
Chapter 16 Scoring Systems 32