1

Lyn C Thomas
Quantitative Financial Risk Management Centre,
School of Management
University of Southampton, UK

ICCR London Oct 4 2011
Modelling credit risk in portfolios of consumer loans:
how to uncrunch credit
Why and how to put economic
factors into risk management
systems
2
Outline
Scoring as a way of modelling retail credit risk
Problems with scoring because no economics involved
Incorporating macro economic impacts into scorecards
Case study from invoice discounting
3
Scoring as a way of modelling
retail credit risk
Retail credit risk models traditionally based on scorecards
Application scorecards and behavioural scorecards
Use sample from 2-3 years ago to relate borrower
characteristics (application, performance, bureau) to
default status 1 year later.
Objective is to get ranking accurate
Measured using KS, Gini
Cut-off chosen using business measures not default probability
Assumption is relative ranking of credit worthiness
constant over time
No need to include economic variables
4
Areas where lack of
economic factors affected scorecards
Problems with bureau scores in US subprime mortgage crisis
Other issue- fraud, disconnect between time periods of model and originator risk
SEC highlighted scores inability to respond to changes in economy












Problems with credit rating agency PD estimates for portfolios of mortgages ( RMBS)
Models did not integrate application scores and economics correctly so ratings were
downgraded ll
Basel required score to translate to long run average probability of default (PD)
Score to PD does vary over time because of economic changes
Without economics in scorecards how to estimate score to long run average PD
How to build models for stress testing
Vantage Score
Details of Real estate scores
2003-2008
5
Decomposition of log odds score
Log odds score ( logistic regression gives log odds scores; linear
regression gives transformed log odds )



Use Bayes theorem to split into population odds plus weights of
evidence ( adjustment due to individual characteristics)
If p
G
p
B
proportion of Goods ( Bads in population)n
( | ) ( | ) ( | )
( ) ln ln ln ln ln ln ( ) ( )
( | | ( | ) ( | )
G G
pop Pop
B B
p p G p p G p G
s o I s woe
p B p p B p p B
| | | | | | | |
= = = + = + = +
| | | |
\ . \ . \ . \ .
x x x
x x x
x x x
( )
( ) ( )
( | )
( ) ln ( | ) ( | ) 1
( | )
1
( | )
1 1
s
s s
p G
s p G p B
p B
e
p G
e e
x
x x
x
x x x x
x
x
-
+ =
= =
+ +
X
x
@
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Why introduce economic and
market variables into score?
Normally scores thought of as static but they are really dynamic : want score
at time t to be

What scorecard gives is
where t
o
is when scorecard built
Solution: put economic conditions, e(t), into scorecard

Obviously s
pop
(e) depends on e
s
pop
(e) is transformation of population default rate; must change over time

Does woe(x,e) depend on e: if so need interaction terms between economic
variables and borrower characteristics
( , ) ( , ( )) ( ( )) ( , ( ))
Pop
s t s t s t woe t = = + x x e e x e
( , ) ( ) ( , )
Pop
s t s t woe t = + x x
0 0 0
( , ) ( ) ( , )
Pop
s t s t woe t = + x x
1 1
( ( )) ( ) ( )
pop m m
s e t c e t c e t = +
1 1
( , ) ( ( ) ( ))
m n
ij j i
i j
woe t c IndicatorFunction x e t
= =
=

x
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Which economic variables?
Little published literature on this
Some work on which variables impact on corporate defaults
Some work on impact of economic conditions on mortgage defaults
Really nothing on unsecured consumer credit
Possible variables
General economy:
GDP
Libor interest rates
Production index
FTSE

Impact of economy on households
Unemployment rate
Price indices
Consumer confidence
House price index

Lending environment
Net lending
Mortgage lending




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Case Study:
Invoice Discounting Example
Scorecard built to estimate default risk of small firms, where
bank is invoice discounter (like factoring)
Give loan using firms invoices to customers as collateral
Scorecard built circa 2005/6 continued to discriminate well
through 2009
But estimate of number of firms defaulting grossly
underestimated in 2008/9.
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Scorecard without Economic Variables
Training In time Test Out of time Test
Gini
62 63 60
KS
46.46 48.83 46.34
HLtest (Chi
square)
43.16 26.93 1470.94
Actual defaults
4666 2247 1409
Expected defaults
4666 2201 605
10
Scorecard with Confidence Index and
FTSE as economics estimate s
pop
(e)

Version 1 Training In time Test Out of time
Test
Gini 63 63 59
KS 47.12 49.00 48.80
HLtest (Chi
square)
32.51 29.95 63.81
Actual defaults 4666 2247 1409
Expected defaults 4666 2202 1306
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Model with interactions
(Confidence and FTSE):
economics estimate of s
pop
(e) and woe (e)
Training In time Test Out of time
Test
Gini 63 63 57
KS 47.03 49.27 44.17
HL(Chi square) 31.75 21.49 81.69
Actual defaults 4666 2247 1409
Expected
defaults
4666 2204 1383
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Introducing economic variables

Adding economic variables directly makes all the difference-
this is putting e in s
pop
(t).
Adding interactions as well made some improvement: but in another
case made no improvement
this is putting e in woe(x)

Adding new variables like ( behavioural trend/economic trend) made
little improvement
( , ) ( ) ( , )
Pop
s s woe = + x e e x e
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Conclusions
Economic variables can be added to scorecards
Need longer time periods in samples to get varying economic conditions

Adding straight variables estimates s
pop
No improvement in discrimination
Impressive improvement in probability of default prediction
Adding interaction variables estimates woe(x,e)
Not clear what improvement this gives
Which variables are affected by economics
Will segmentation work better ?
Need to ensure not all time dependent changes have to be explained
by economics
Alternative approach is to keep scorecard fixed and to use economics in
score to PD transformation
Reinterpret hazard function approach in this way
Roll rates/markov chains can be functions of economics