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During the past decade, increasing competition from credit unions, brokerage houses, finance companies, and monoline lenders has changed the nature of the banking industry. One of the most dramatic shifts has occurred in the lending function.
When loan underwriting was at the mercy of a pool of underwriters using manual analysis and judgment, decisioning was measured in days. Credit-scoring, using enhanced computer technology, has brought the lending process to a point at which decisioning is measured in minutes. This efficiency has allowed banks to expand their lending into national markets and produce underwriting volumes once considered unfeasible. Scoring has also reduced unit underwriting costs while yielding a more consistent loan portfolio that is easily securitized. For many mid-size and large banks, credit-scoring has become key in remaining competitive.
What Is Credit-Scoring?
In its most distilled form, credit-scoring is a system that uses statistical methods to predict the creditworthiness of loan applicants and existing loan accounts. Scoring uses applicant or borrower data in empirically derived algorithms to predict a population's repayment behavior. Clearly, credit-scoring is a risk management tool. Scoring systems can help a bank ensure more consistent underwriting and can provide management with more insightful measures of credit risk.
However, because the population used in developing the scorecard is static and the applicant or borrower data are historical, performance of the scorecard carries its own risks. Success of the scorecard will be affected by changes in:
* The nature of the applicant population (often a result of changes in product marketing programs).
* Consumer behavior (witness the wider acceptance of bankruptcy).
* The economy (job losses usually translate into higher loan losses).
Thus, scoring systems must be carefully managed through a comprehensive monitoring program even after installation to ensure continued effectiveness in predicting credit behavior and performance.
Today, scoring is also used in marketing, credit administration, loan pricing, fraud detection, and collections. However, this article is focused on how institutions can manage scoring as an underwriting tool more effectively. These ideas are useful in managing "off-the-shelf" scorecards and custom scoring systems.
Ten Steps to Safer Scoring
Bank examiners are in a good position to see practices in numerous banks and to observe their best practices. After numerous such visits and observations on credit-scoring and subsequent discussions with vendors of credit-scoring systems, 10 practices leading toward safe, efficient, and profitable use of credit-scoring emerged.
1 Scoring systems are developed and implemented by a team of loan production, risk managers and technology staff, …