Professional Documents
Culture Documents
A R T I C L E
specializes in the ogy. Among them, credit scoring is more efficient What Are The Different Types
application of the than having credit department personnel evaluate Of Credit Scoring Systems?
Internet and the every potential sale, which saves money—a major The different types of credit scoring systems most
utilization of decision consideration for corporate America these days. usually used to evaluate credit risk in B2B situa-
support technology
for improving credit
Additionally, Sarbanes-Oxley and its requirements tions are:
department risk point to the use of credit scoring as a good method • Judgmental/Rules-Based Systems
analysis capability and for improving internal control over risk-based deci- • Neural Network-Based Systems
collection department sions. For the most part, however, regardless of the • Statistical-Based Systems
efficiency. He can type of scoring system in place, businesses are not • Genetic Algorithm-Based Systems
be reached at getting everything they can from the implementa-
516.313.1020
tion of a credit scoring system. They all have strengths and weaknesses and the
or via e-mail at
albie@afassociates.org. nature of your business, the amount of risk you are
So, there is more that can be done, however, before willing to take, and the funds available to develop
we get into what it is, and why it should be done, and implement the scoring system will play a major
let’s briefly review what types of credit scoring part in determining which technology is best for
systems are available and the differences between your company to employ. To be sure that you employ
them. If the reader needs more than a brief review, the one that is best for your company, you should
you may want to take a look at an article I wrote, review all of the options before you make a decision.
Credit Scoring Basics, that appeared in the March
2003 issue of Business Credit. This article covers the Judgmental/Rules-Based Systems
nature of a credit scoring model, credit scorecards, Judgmental/rules-based systems evaluate credit
the requirements for maintaining a credit scoring worthiness using a formula or a set of rules based
system, and how to determine whether to build or upon internal and external credit experience. The
buy, subjects that will not be covered here. determination of the rules used and their associated
values is a manual process that is dependent upon
What Is Credit Scoring? certain individuals’ intuition and past experience.
Essentially, credit scoring is a systematic method
for evaluating credit risk that provides a consistent Some of the strengths of this procedure are:
analysis of the factors that have been determined
to cause or affect the level of risk. Factors are • It is based on accepted credit risk standards
usually determined through an analysis of histori- (judgment) and takes such items into
cal bill payment activity as well as various descrip- consideration as:
tive parameters that may be used to classify an - Customer payment history
account into one of several defined categories or - Bank and trade references
customer classes. - Credit agency ratings
- Financial statements
Once the analysis necessary to create the credit scor-
BUSINESS CREDIT MARCH 2005
• It is inefficient to build as all of the work is done manually • Can deal with non-linear relationships
• The factor weights can be biased towards data elements • Correlations between factors are accounted for
that may not be mathematically relevant to risk • Models are adaptive in that the nature of forecast errors
• The effect of a specific factor can not be accurately meas- (i.e., bad model decisions) can be easily evaluated and the
ured and, therefore, the sensitivity to a change in that models improved accordingly
factor can not be accurately determined
• Risk cannot be quantified as expressed by the probability Some of its weaknesses are:
of payment within a specific time period or of default
• It is difficult, if not impossible, to determine the source of • Results are essentially a “black box”
error if the system’s predictions are not accurate, therefore, • Credit personnel have no idea of the structure of the credit
updating the system in an effort to improve results is a hit scoring model, i.e., the weights connecting nodes between
and miss proposition model layers and, therefore, cannot properly evaluate the
model’s decisions
Neural Network-Based Systems • Model output must be accepted by credit personnel based
These systems utilize artificial intelligence algorithms applied on the word of an “expert”, i.e., the consultant who devel-
to historical data to find relationships between account char- oped the model, who is rarely a competent credit analyst.
acteristics and the probability of default. They have the capa- • Almost all applications in the credit industry have been in
bility to classify accounts into various credit risk classes such consumer-based risk evaluation
as: good, indeterminate, delinquent, charge-off and bankrupt.
Statistical-Based Scoring Systems
Some of the strengths of this procedure are: Statistical-based scoring systems utilize statistical analysis,
usually in the form of a multivariate non-linear regression
• Has the ability to determine the characteristics that are model, (remember Y = a + bX, only with more variables, hence
most important in predicting credit risk multivariate), to estimate the probability a customer will
• In some circumstances, may be more flexible than standard default or become delinquent. These systems are very similar in
statistical techniques as no assumptions are made about operation to judgmental systems except that the factors used
the relationships of the risk factors prior to analysis and their assigned weights are based on statistical analysis—
Strength in Numbers
47
F E A T U R E A R T I C L E
not human judgment—of a company’s past operations together • Extremely limited knowledge of this technology within
with other data considered by the analyst as pertinent. the business community, almost all practitioners are
university-based
Some of the strengths of this procedure are: • The few business-based practitioners have little experience
in applying GAs to credit risk analysis
• Can use and evaluate any internal and external data to • In-house statisticians may resist the implementation of a
score accounts technology they do not know or understand
• Many factors are considered individually and simultaneously
• The model development process calculates and analyzes the Why Use Scientific-Based Credit Scoring?
correlation between all of the variables to identify factor With respect to neural, statistical and genetic algorithm-
tradeoffs and eliminate redundant relationships based credit scoring systems, the main reasons for using one
• Variables can be chosen by the statistical analyst to ensure of them are:
the relationships makes financial sense (e.g., older firms • They provide a significantly more accurate analysis by
are less risky then younger firms) delivering 10 percent to 30 percent—or more—improve-
• Users are able to identify sources of estimation error and ment in predicting customer credit risk over non-scientific
improve model accuracy methods
• The cause of prediction error in scientific-based models
Some of its weaknesses are: can be identified and these models can be improved and
kept current. Updates can be scheduled on a regular basis,
• Need someone with a statistics background and experi- or as needed
ence with credit information to build and implement • They can provide the basis for meeting certain require-
the model ments of Sarbanes-Oxley
• Bulk of analyst’s time may be spent in data preparation
and analysis of statistical relationships, rather than in Providing the work discussed in the next section is accomplished:
model building
• If there are a lot of variables to consider, an analyst may • They can help in the development of optimal strategies for
need to predetermine the important variables based on a dealing with at-risk account.
separate analysis • Scientific-based credit scoring can dramatically increase
• Some statistical models can be difficult to implement credit and collection department productivity
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F E A T U R E A R T I C L E
2. Score all of your accounts using the new system, and clas- groups, apply one of the other procedures you determined
sify them into homogeneous groups or strata. If we assume in 1. above.
scores can range from 0 to 100, then perhaps one strata
contains all of the accounts that scored from 0 – 25; a 5. Ninety to 120 days after you have started the test,
second strata might contain all of the accounts that scored compute the percentage of DCF achieved for each group
from 26 – 50, and so on. You may also want to segment and compare it to the historical group average. You can
the strata if there are different divisions, i.e., even though also compare the percentage DCF on an account-by-account
accounts have the same score there is another characteris- basis. There is a standard statistical test you can utilize to
tic that you believe makes them different; such that they perform this comparison that will determine whether the
might respond differently to the same collection strategy. difference between your history and the current results are
significant, i.e., the alternative procedures have produced a
3. Within each stratum, select a random sample of some measurable change.
percentage of the accounts. The size of the sample can be
determined based upon the variance within the strata. 6. If the alternative collection procedures have produced a
I would suggest that this variance be based upon a meaningful change in the bill payment activity of certain
discounted cash flow (DCF) analysis of the accounts past classes of accounts, you’ll need to consider whether you
payment history converted into a percentage of the maxi- should change your collection activities relative to all of
mum DCF possible, where the maximum DCF occurs if the the types of accounts where a more favorable percentage of
invoice is paid at the time of shipment. Realistically, this DCF has been realized. A simple rule-based program that
is the statistic you are trying to improve in that it meas- can determine the type of collection procedure required on
ures the time-value of money. The sooner after shipment an account-by-account basis and then direct the personnel
an invoice is paid; the greater the percentage of the assigned to these accounts how and when to handle them
maximum possible DCF is achieved. Your credit scoring can be readily designed and implemented into an inhouse
systems provider can help you with this. or ASP based computer system.
4. Next, divide the sample within each stratum into three If you want to achieve all of the benefits promised by scien-
groups. You can do this by assigning every third account tific-based credit scoring, an analysis similar to the one
to a different group. described above should be part of any credit scoring project.
While this procedure may seem a little complicated, anybody
For one of the groups, within each stratum, apply your with a basic knowledge of statistical sampling should be able
normal collection procedures. For each of the other to help you.
Strength in Numbers
–Expanded Knowledge
–Career Opportunities
–Heightened Professional
Recognition
–Standards of Excellence
BUSINESS CREDIT MARCH 2005
Professional Certification–
A Recognized Success Path
For details visit www.nacm.org
or call 410.740.5560.
The Right Way
49