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Are traditional bureau risk scores appropriate for the Basel II Accord?(INTERNATIONAL SECTION)(Accord on the International Convergence of Capital Measurement and Capital Standards, 2001)
As banks prepare to satisfy the Basel II Accord requirements, many issues need to be addressed, including the creation of internally calculated estimates for Probability of Default (PD).
Currently in the United States, only a limited number of banks are required to update their systems to comply with Basel II at the Advanced Internal Ratings Based (A-IRB) level. However, many banks outside of this group are choosing to opt in or introduce some of the AIRB components should they choose to participate at a later date. Despite all the criticisms of Basel II and the requirements for compliance, the Accord is based on sound risk-management practices, making it a wise decision for all banking institutions.
For retail portfolios (consumer and small business), PD is viewed as one of the most straightforward risk inputs to be derived. That is a reasonable conclusion, since forecasting the probability of an account's achieving default status in the next 12 months is very similar to forecasting the likelihood of being delinquent (an issue that has been addressed by traditional credit scores for decades). However, does this mean that a credit score currently available can be used for PD? Scores typically have values in the range of 0 to 1,000, so a conversion of the score to a probability number between 0 and 1 is required. But is there more to it than that?
Some organizations have begun to question the assertion that a traditional bureau risk score is adequate for PD estimation. Research by Experian-Scorex has revealed that there are weaknesses in traditional bureau risk scores utilized for PD and that available alternatives produce significantly better results. Regulators, rating agencies and lenders all know that a bureau score value means different things, depending on issues such as product line, bureau data source and lender. The myth of a score of 700 being universally applicable is crumbling fast. Because of this, a validation for a particular data set is always required to determine how to interpret a score for a specific portfolio, along with an adjustment (recalibration) if a particular score-to-bad-rate relationship is required. This validation also needs to be performed separately for each credit reporting agency used, since the score may not denote the same thing for your portfolio with data from multiple agencies. Scorecard developers that provide scores across multiple bureaus attempt to match performance across bureaus, but this is done at an aggregate level. Therefore, the alignment may not be correct for your portfolio.
Although bureau scores are easy to access and use, you must validate their performance for your particular decision environment. For PD, accuracy of forecast is even more important than it is when a score is used for account decisioning. Therefore, it is crucial to test, validate and recalibrate when necessary.
When working with Basel II PD, there is more to the issue than just calibration. Most of the traditional bureau risk scores are built with a 24-month outcome. This means they are optimized to forecast the likelihood of being delinquent over the next 24 months. However, for regulatory capital calculations, a forecast over the following 12 months is required. If you have observed a bad rate from point of origin, you are likely to have noticed that it continues to increase well beyond 12 months--typically flattening out in the 18- to 24-month period. This is why 24 months is used for the outcome period with traditional risk scores.
What does this mean if the same score is used as the basis for estimating PD over 12 months? To test this, Experian-Scorex constructed new bureau scores for PD based on the Basel II requirements of a 12-month outcome period and a 90-plus-day default definition. The performance of two traditional bureau risk scores was compared, calibrated to the Basel II requirements for outcome period and default definition. When using the Basel II-specific bureau score, significant improvements in performance were observed across all three of the product areas--mortgage, other installment and revolving. The results were dramatic, as shown in the following summary:
- Experian-Scorex Study Reveals that Basel II Specific Scores Outperform...
- Press release article from: PR Newswire April 22, 2004 700+ words
...10% or more for the Basel specific score, as compared to two other general risk scores. Another indicator of...mortgage arena, the Basel II score identified 62...whereas the two general risk scores only identified 38...
- Scorex in U.S. Launch of Basel II-Tailored Product.(software)
- Magazine article from: American Banker Lee, W.A. December 9, 2003 700+ words
...organization that has provided a Basel-specific score." The Scorex...cannot be accurately used for Basel II compliance because those...about using traditional bureau risk scores and calculating from that for Basel II. The truth is, you'd...
- Operational risk concerns intensify.(New Basel Capital Accord)(Brief Article)
- Magazine article from: Australian Banking & Finance jonhson, byram April 30, 2001 700+ words
...inclusion of operational risk in the New Basel Capital Accord (issued January 2001...operational risk scorecard, which provides risk scores by business lines and by risk categories. Capital is then calculated by combining risk scores with exposure indicators and regulatory...
- FTC Won't Give Consumers Access to Credit `Risk Scores'
- Newspaper article from: The Washington Post Albert B. Crenshaw September 3, 1995 700+ words
...bureaus to disclose to consumers their "risk scores," which merchants and banks use to...technology-intensive industry. Credit risk scores, which are generated by computer models...that best suit their needs. The credit risk scores generated by the credit bureaus, primarily...
- Credit bureaus not required to reveal risk scores. (Federal Trade Commission...
- Magazine article from: American Banker Fickenscher, Lisa September 12, 1995 700+ words
...regarding the disclosure of so called "risk scores," the Federal Trade Commission has...credit reports requested by consumers. Risk scores are a numerical analysis of all the...argued that mandating the disclosure of risk scores would only confuse consumers, because...
- Businesses often use credit risk scores.
- Newspaper article from: Ventura County Star (Ventura, CA) June 28, 2005 700+ words
...pricing, but the FICO score and other risk scores are increasingly important for many...point. Employers rarely use credit risk scores, Watts said, although they do use...Insurance companies can use insurance risk scores, which include some credit information...
- Fair, Isaac Credit Bureau Risk Scores Mark 10 Years as Decision-Making 'Gold...
- Press release article from: PR Newswire September 7, 1999 700+ words
...the customer life cycle. Since then, risk scores and other types of Fair, Isaac credit...scores, Fair, Isaac credit bureau risk scores are the most widely used analytic product...Today, Fair, Isaac credit bureau risk scores enjoy widespread use -- Fannie Mae...
- TRW opts for more detailed reports in wake of debate over risk scores. (TRW...
- Magazine article from: American Banker Fickenscher, Lisa January 5, 1996 700+ words
...bureaus won't be divulging consumer risk scores anytime soon, but at least one major...are not required to disclose so called risk scores. The FTC and the financial services...whether consumers had a right to see risk scores, in which a consumer's creditworthiness...