Gini Coefficients and the Economics of Credit Scoring
On a global scale, billions of dollars in debt are granted every year using decisions derived from credit scoring systems. Financial institutions critically depend on these quantitative decision to enable accurate risk assessments for their lending business. In this sense, as with any tool that serves a business purpose, the application of credit scoring is not ultimately measured by its statistical properties, but by its impact in business results: how much can Credit Scoring help to increase the benefit and/or to decrease the cost of the lending business.
Assessing Credit Scoring from a business perspective could sound pretty obvious. However, given the typical compartmentalization of roles that could exist at lending institutions, where Risk and Modeling teams can be completely separated from Commercial departments, it could be easy sometimes to focus too much on the statistical aspects of credit scoring such as Ginis, and forget the ultimate business nature of its purpose. Although there is a clear positive relationship between economic benefits and predictive power, there are also certain elements that can affect the balance between costs and benefits. In this post, we discuss some of these elements and explain their role in the cost-benefit analysis of credit scoring.
The benefits of credit scoring
The benefit of credit scoring derives from its ability to accurately identify good customers, and discriminate them from bad customers. The more good customers a model can identify, the greater the interest income that can be generated from a credit portfolio. And the more bad customers it can discriminate, the lower the losses for the credit portfolio. In this sense, the economic benefit of credit scoring can be amplified by two things: the volume of customers, and the size of the credit disbursed to these customers.
Take for example the portfolio of microfinance institution “A” with several thousands of customers but very small loan amounts, and compare it against a smaller microfinance institution “B” providing loans of the same size to a portfolio of just a few hundred customers. Both institutions can see a similar increase of 1% in the predictive power of their credit scoring models, however, the increase in economic benefit yielded from this increase in predictive power will be different just because of the different sizes of portfolio volumes. Everything else being equal, the higher the volume of the portfolio, the higher the potential economic benefit of credit scoring.
The same can be argued for the size of credit disbursed to the customers of a portfolio. For example, take an SME lending institution with just a few thousands of customers but with relatively high credit amounts in the hundreds of thousands of dollars. An increase of 1% in predictive power could bring just a handful of new good clients into the portfolio, or avoid the disbursement of a handful of very bad loans. However a change in just a handful of good or bad clients can be enough to generate a considerable increase of economic benefit in the portfolio given the large size of the loans.
The costs of credit scoring
The costs of Credit Scoring can be split in two parts. First, the cost of developing a new model, and secondly, the cost of implementing and maintaining credit scoring models.
If we assume lending institutions are at a stage of technological maturity in which all the necessary data to create a credit scoring model exists and is continuously updated with certain level of quality and integrity, then the first type of cost just depends on the complexity of the modeling process. The whole process of building a model includes data extraction and cleaning, feature engineering, feature selection and the selection of a classification algorithm.
Depending on the lending institution, this process can be handled by a single data scientist (e.g. think of the CRO of a small Fintech startup), or it can be handled by a large department including many different teams with different roles such as data engineers, data scientists and software engineers (e.g. think of a large multinational bank). At the same time, the teams in charge of the model building process can be comprised of junior analysts fresh out of college using well-known standard techniques or include teams of PhDs in computer science doing advanced machine learning. At the end, the cost involved in developing the credit scoring models will depend on how much complexity and sophistication can be afforded and/or needs to be put into the process.
Once the model has been built, it also needs to be implemented and monitored over time. The costs involved are not trivial. Again, they will depend on the stage of technological maturity of the financial institution and the complexity and sophistication required. For example, in some cases the implementation of a credit scoring model can be as simple as creating an Excel calculator loaded with the coefficients of a logistic regressions where some values are manually inputted by a Loan Officer to get a score (e.g. think of a small MFI in the rural area of a developing country). Or it can be as complex as a Python package in a cloud-hosted decision engine integrated in the online platform of a large bank. The handling of big data, software development and testing, as well as the security and legal aspects involved in the deployment of a credit scoring system can considerably increase its costs. And all this, without even considering if the teams that will monitor the performance of the models implemented on a defined frequency basis are dedicated full time, or they are just the same team that also did the modeling and/or deployment.
Bottom-line: The statistical classification accuracy measured by Gini coefficients are indicative of some part of the benefits of using credit scores, but they are not the most important nor the final metric when assessing the cost-benefit of credit scoring. The reason is because the benefits of credit scoring can be influenced by the volumes of customers and the size of the credit. And the costs of credit scoring ultimately depends on the stage of technological maturity of the lending institution, as well as how much complexity and sophistication can be afforded and need to be put in the development, deployment and monitoring of credit scoring models.
So next time you need to make a decision about using Credit Scores to boost your lending business, ask how much they can help to increase the benefits of the business, and how much they can help to decrease its cost. The final decision will depend on a lot more than just Ginis.
At LenddoEFL, we have the expertise to help you boost the benefits and reduce the costs of credit scoring using traditional and alternative data. Contact us for more information here: https://include1billion.com/contact/.