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Universidad Complutense de Madrid

Mster en Ingeniera Matemtica


Curso 2007-2008

Modelling Week
Second Edition
June 16 June 24, 2008

Credit Scoring Modelling for


Retail Banking Sector

Problem raised by Accenture.

Coordinators:

Ignacio Villanueva (UCM).

Estela Luna (Accenture).

Credit Scoring Modelling for


Retail Banking Sector

Team members:

Elena Bartolozzi (Universit di Firenze)


Matthew Cornford (University of Oxford)
Leticia Garca-Ergn (UCM)
Cristina Pascual Deocn (UCM)
Oscar Ivn Pascual (UCM)
Francisco Javier Plaza (UCM)

Credit Scoring Modelling for


Retail Banking Sector

Index

Introduction
Methodology and Data
Univariate and Multivariate Analysis
Model Creation
Validation
Calibration

Credit Scoring Modelling for


Retail Banking Sector

Index

Introduction
Methodology and Data
Univariate and Multivariate Analysis
Model Creation
Validation
Calibration

Credit Scoring Modelling for


Retail Banking Sector

Our problem is concerned with who a bank should loan


its money to.
When a client applies for a loan, the bank would like to
be sure that the client will pay back the full amount of
the loan.
We need effective models that allow us to predict if a
client will pay back the loan.
What we have is historical data for several variables.
We are trying to fit a model to this historical data so we
can estimate a probability of default.

Credit Scoring Modelling for


Retail Banking Sector

Index

Introduction
Methodology and Data
Univariate and Multivariate Analysis
Model Creation
Validation
Calibration

Credit Scoring Modelling for


Retail Banking Sector

Our data is provided by Accenture and include details of


completed loan agreements

The variables included are:

Age
Income
Wealth
Marital Status
Length as a Client
Amount of Loan
Maturity
Default

Credit Scoring Modelling for


Retail Banking Sector

Sample Selection

We split the sample into two parts

The modelling sample

The validation sample

Credit Scoring Modelling for


Retail Banking Sector

Modelling Sample

A random sample from the data is selected.

The size of the modelling sample is about 2/3 of the


original data

This new sample is used to create the model.

Validation Sample

The remaining data is used to validate the model

We test how many defaults the model predicted and


which of them really did default.

Credit Scoring Modelling for


Retail Banking Sector

Index

Introduction
Methodology and Data
Univariate and Multivariate Analysis
Model Creation
Validation
Calibration

Credit Scoring Modelling for


Retail Banking Sector

We have a dependent variable, which is default, and


some independent variables (age, income,)
First of all, we do univariate analysis.
For each variable, we calculate some statistics like mean,
standard deviation, skewness
We plot some histograms
This information can be use as a first check before
applying the model.
It would be better if the data were homogeneous.

Credit Scoring Modelling for


Retail Banking Sector

Univariate Analysis

Weve used SAS software to generate these statistics:

output.htm

SAS Graph v9

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

This kind of analysis is very useful to detect outliers or


transcription mistakes.

Credit Scoring Modelling for


Retail Banking Sector
Multivariate Analysis

Correlations

Credit Scoring Modelling for


Retail Banking Sector

Chi-squared test

We try to calculate which of the variables are explanatory


variables, i.e. which variables does default depend on.
We use the chi-squared test for that:
2
(
O

E
)
i
2 i
Ei
i 1
n

To begin with, we must discretize the continuous variables using


percentiles.
After doing Chi-squared test, we look at the p-value.

If p-value<0.05, we reject independency

If p-value>0.05 we do not reject independency.

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

Index

Introduction
Methodology and Data
Univariate and Multivariate Analysis
Model Creation
Validation
Calibration

Credit Scoring Modelling for


Retail Banking Sector

According to the results of the Univariate and


Multivariate Analysis, the variables we include in our
model are:

Age
Income
Wealth
Marital Status
Maturity

Credit Scoring Modelling for


Retail Banking Sector

We apply a logit model using proc logistic in SAS and


glmfit in MATLAB as well, obtaining the same results.
exp( j 0
k

( x0 ,..., x k ) ( x)

1 exp( j 0

x)
j

( x)
k
exp( j 0
1 ( x)
Logit ( ( x)) log

x)
j

x)
j

( x)
0 x1 1 ... x k k
1 ( x)

Credit Scoring Modelling for


Retail Banking Sector

Credit Scoring Modelling for


Retail Banking Sector

Intercept
Age
Income
Wealth
Marital Status
Maturity

-1.85136
-0.02678
0.10025
-0.01761
0.79651
0.00892

There must be some diferences because we randomize


the sample.

Credit Scoring Modelling for


Retail Banking Sector

So, our model is as follows:

1
P(Default/x)=
1+e-
Where -1.85 -0.026*Age+0.1*Inc-0.017*Wlth+0.79*Marit+0.0089*Matur

Credit Scoring Modelling for


Retail Banking Sector

Index

Introduction
Methodology and Data
Univariate and Multivariate Analysis
Model Creation
Validation
Calibration

Credit Scoring Modelling for


Retail Banking Sector

Model statistics:

Credit Scoring Modelling for


Retail Banking Sector

Powerstat is a method to measure the likelihood of the


model
The data is sorted from worse to better according to the
probability of default calculated with our model.
The perfect model will have the total amount of defaults at
the beginning.
We plot accumulated defaults against accumulated
observations.
Powerstat compares the area between the perfect model,
our model and a random model.

Credit Scoring Modelling for


Retail Banking Sector

Powerstat (Gini Index):

Credit Scoring Modelling for


Retail Banking Sector

Validation

Once the probability of default for each client is found, the


question is how to choose the level that classifies if a client
will default or not.

We use the validation data to predict with our model how


many observations will default and compare with which of
them are really did default.

Repeating the process with several random samples, the


probability has very low deviation and rounds 0.77.

Credit Scoring Modelling for


Retail Banking Sector

Index

Introduction
Methodology and Data
Univariate and Multivariate Analysis
Model Creation
Validation
Calibration

Credit Scoring Modelling for


Retail Banking Sector

The expected Loss is defined as:

EL = PD * EAD * LGD

PD is the percentage of default.


Is defined as default probability calibrated for a year.
EAD is the exposition to default.
LGD are losses on the exhibition.

Credit Scoring Modelling for


Retail Banking Sector

Scoring allows us to sort people against default.


However, these probabilities do not take into account when the
default happens.
This is the reason for calibration.
We want to obtain the yearly average probability of default
We need a sample of people observed in periods of years.
The model is applied and the sample is sorted by score.
We obtain a default observed rate:

Rate A (C score ) B

Minimizing the Least Squares Error with the MATLAB function


fminsearch, we obtain the values:
A=0.0004

B=3.7410

C=2.7870

Credit Scoring Modelling for


Retail Banking Sector

The Credit Scoring Model was solved quickly


and didnt cause too much difficult.

We asked Accenture to bring another, related


problem.

We now introduce the Problem of Capital


Allocation.

The Problem of Capital Allocation

Index

The Problem of Capital Allocation


Implementation
Conclusions

The Problem of Capital Allocation

Index

The Problem of Capital Allocation


Implementation
Conclusions

The Problem of Capital Allocation

In this problem a lender has a fixed amount of money to lend,


EAD, between n blocks of similiar customers

How to distribute the money between the blocks to maximize


the profit?

Each block has associated with it an interest rate i, an a priori


probabilty of default PDi, the loss given default LGDi and the
number of customers Ni.

If each customer in each block is independent of the rest then


we can easily compute the probability of k defaults.

The Problem of Capital Allocation

But the customers are correlated via the economy. We can use
Gaussian Copula to introduce a default random variable for each
customer:
m

Z i a ijY j ri wi
j 1

( Z i ) PDi Default

Then for a particular state of the economy we have that the


independent probability of default for each customer is:
m

1
i
( PDi ) a jY j
j 1

pi

ri

The Problem of Capital Allocation

We use the binomial distribution:

N i
Ni k
k
pi (1 pi )
k

P(k defaults )

When N is big enough (in the order of 10^3) we can aproximate this
binomial with normal random variable Di:

Di : N ( N i pi , N i pi (1 pi ))

The Problem of Capital Allocation

We define the loss distribution as:

i EAD
L
( LGDi Di ( N i Di ) i )
Ni
i 1
n

As L is a sum of independent normal distributions,

L : N ( L , L2 )

The Problem of Capital Allocation

To measure risk we use Value at Risk (VaR) with a 99%


confidence level. So the problem becomes:

Minimise

f ( ) L
n

Subject to:

i 1

-2.3262 L + L = VaR99
Where VaR99 is the fixed level of risk the lender is willing to take.

The Problem of Capital Allocation

Index

The Problem of Capital Allocation


Implementation
Conclusions

The Problem of Capital Allocation

We start with 3 blocks to make the problem easier.

We have to find the s that minimise the expected loss.

We have two approaches to solve this problem.

The Problem of Capital Allocation

First we fix s and find the VaR99 and Expected Loss for
each set of s (Black dots).

The Problem of Capital Allocation

Then we find the s that minimise the Expected Loss for any fixed
VaR99 (Red Dots) using the MATLAB function fmincon.

As we can see we got very good agreement between the two


approaches, on the order of 10^(4).

The Problem of Capital Allocation

Here we have the results for 5 blocks, which took considerably


longer than with 3 blocks.

The Problem of Capital Allocation

Conclusions

Analytical method outperformed the simulation of wi as


expected.

Optimise for more than 3 blocks the choice of optimiser


needs to be investigated furhter.

Another interesting question is to look at the relationship


between the efficient border and the interest rates charged
for each block.

The Problem of Capital Allocation

Questions?