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IMPLEMENTING a CREDIT RISK MANAGEMENT SYSTEM BASED on INNOVATIVE SCORING TECHNIQUES By

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IMPLEMENTING a CREDIT RISK MANAGEMENT SYSTEM BASED on INNOVATIVE SCORING TECHNIQUES By IMPLEMENTING A CREDIT RISK MANAGEMENT SYSTEM BASED ON INNOVATIVE SCORING TECHNIQUES by LINDA DELAMAIRE A thesis submitted to The University of Birmingham for the degree of DOCTOR OF PHILOSOPHY University of Commerce and Social Science Department of Economics The University of Birmingham February 2012 University of Birmingham Research Archive e-theses repository This unpublished thesis/dissertation is copyright of the author and/or third parties. The intellectual property rights of the author or third parties in respect of this work are as defined by The Copyright Designs and Patents Act 1988 or as modified by any successor legislation. Any use made of information contained in this thesis/dissertation must be in accordance with that legislation and must be properly acknowledged. Further distribution or reproduction in any format is prohibited without the permission of the copyright holder. Abstract In recent years, most developed countries have suffered a severe recession due to a financial crisis starting in the US with mortgages loans. The lack of credit risk management has been pointed out as one of the causes of this bank panics. To avoid a similar situation, the credit card companies need to have proper risk management tools. This thesis presents a credit scoring system which aims at setting credit lines and thus, controlling credit risk. It includes three types of models: application scorecards, early detection scorecards and behavioral scorecards. They have been built on real and recent data coming from a German credit card company. The models have been built with a training sample and validated accordingly, using logistic regression. Information value and validation charts have been used for comparing the models. In the scoring process described, the scorecards are used in a sequential order. The author shows that minimizing losses might not be optimal in order to maximize profit. Finally, the author presents possible extensions to the research. The author hopes that the microeconomic analysis of the mechanics of a particular lender’s credit allocation process described in this thesis can play some part in preventing future financial crisis. 2/374 Dedication To Hanène for her friendship & To my mother for her support 3/374 Acknowledgements My utmost gratitude goes to the department of economics of the University of Birmingham for allowing me to join this PhD program even though the conditions were particular as I was doing it abroad. I would like to thank my supervisors, Prof. Peter Sinclair and Dr. David Dickinson for their expertise, kindness, and most of all, for their patience. I thank especially Prof. Peter Sinclair for sharing his views and his research insight. I also appreciated a lot his availability and prompt replies and comments to all pieces of work submitted. His advice has clearly impacted on the quality of this thesis. I believe that one of the main gains of this three-years program was making research and at the same time being in a professional environment. I am greatly indebted to the company X for allowing me to use their data. My special thanks to the management, for having suggested and encouraged this research. I wouldn't be performing this work without Kyle Hansen, who first brought me into the world of credit risk and with whom I began to learn about credit scoring and their application in the real world. Not only a great expert and colleague, he has also been a miles stone in my professional development. I wish to thank everybody that has influenced my career. From the people who first persuaded and got me interested into the study of statistics and especially those who also played a significant role in my professional career. Even though listing everybody might be too long, I want to say thank to Flemming Yndgaard for introducing me to the research area and motivated me to take this direction. I say thank very much to all of my friends who have supported me. In particular, it is difficult to overstate my appreciation to Hanène for her help and support in joining this program. I cannot finish without saying how grateful I am with my family. I wish to thank my parents. They have always supported and encouraged me to do my best in all matters of life. 4/374 Table of contents Introduction ................................................................................................................................... 15 Chapter 1: The Credit Card market ............................................................................................... 18 1.1 Banking industry ............................................................................................................. 18 1.1.1 What is a bank? ........................................................................................................... 18 1.1.2 Bank functions............................................................................................................. 19 1.1.2.1 Asset services .......................................................................................................... 20 1.1.2.2 Liability services ..................................................................................................... 20 1.1.2.3 Transformation services .......................................................................................... 20 1.1.3 Managing risk in the banking industry ........................................................................ 21 1.1.3.1 Credit risk ................................................................................................................ 22 1.1.3.2 Market risks ............................................................................................................. 24 1.1.3.3 Systemic risk ........................................................................................................... 24 1.1.4 Banking regulations..................................................................................................... 27 1.1.4.1 General framework .................................................................................................. 27 1.1.4.2 Basel 3 ..................................................................................................................... 28 1.2 What is a Credit Card? .................................................................................................... 30 1.2.1 Definition of a credit card ........................................................................................... 30 1.2.2 The History of the Credit card..................................................................................... 30 1.2.3 A credit card as a transaction medium ........................................................................ 32 1.2.3.1 Cash ......................................................................................................................... 33 1.2.3.2 Cheques ................................................................................................................... 33 1.2.3.3 Debit Cards .............................................................................................................. 34 1.2.3.4 Credit Cards ............................................................................................................. 35 1.2.4 Credit card as a source of credit .................................................................................. 37 1.2.4.1 Borrowing mediums ................................................................................................ 37 1.2.4.2 Credit Cards ............................................................................................................. 39 1.3 Credit card usage ............................................................................................................ 40 1.3.1 Type of users ............................................................................................................... 40 1.3.1.1 Convenience users ................................................................................................... 40 1.3.1.2 Revolvers ................................................................................................................. 41 1.3.2 Overindebtedness ........................................................................................................ 41 1.3.2.1 Financial Literacy .................................................................................................... 42 1.3.2.2 Debt literacy ............................................................................................................ 44 1.3.2.3 Financial awareness ................................................................................................. 46 1.3.2.4 Costs of ignorance ................................................................................................... 48 1.3.2.5 Other consequences - Savings ................................................................................. 49 Chapter 2: Credit Risk management in the Credit Card industry .................................................. 51 2.1 Risk management and credit risk .................................................................................... 52 2.1.1 Introduction to financial risks ..................................................................................... 52 2.1.2 Principles of credit risk ............................................................................................... 53 2.1.2.1 Definition of default ...............................................................................................
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