5. How many explanatory variables are used in a typical credit scorecard?

Why aren’t more

explanatory variables included?
Most empirically derived credit scoring systems have between 10 and 20 variables.

For the purposes of the discussion, the period will be assumed to be a year. These individual’s
application from data is then combined with their credit bureau data which the bank obtained at the
time of the application. This combined data usually constitutes 50 or more variable. These variables will
become the explanatory variables which will be used in the regression, although they will be culled
down to around 10 variables later in the process.

The data set is comprised of 50 or more explanatory variables and a binary dependent variable which is
specified as ‘good’ or ‘bad’. When larger banks undertake the development of a credit scrorecard, there
might be a million or more applicants in the data set.

There will be correlation between the variable added and the variable with the coefficient of the
changing significant. Strong multicolinearity is not very likely because multicollinearity will imply high
standard errors of estimated coefficients and as a result more insignificant coefficients.

6. Credit scoring developed in response to the need of financial institutions to be able to

process an ever growing number of applications with ever decreasing resources. Discuss this
development.
Credit scoring developed alongside the growth of credit and the need to generate provable accurate
information about different business and personal portfolio segments. With the increasing demand for
funds, old systems and methods could no longer cope with the volume of processing.

Financial institutions were faced with a challenge: re-invent themselves by application of new efficient
and statistically reliable methods or face the threat of extinction because of an ever-increasing cost
structure with a decreasing cash flow runoff.

7. What are the two broad categories of credit scoring? How do they ralate to each other?
Are they mutually exclusive and do they create tension within the credit assessment
structure?
Two broad categories of credit scoring:

 Accounting based systems

 Quantitative credit screening: credit approval models, behavioural scoring models.

Both categories rely on the use of statistical measures. The major diference is the predictive nature of
the accounting–based models as opposed to the rear-view analysis of the quantitative models. The
fundamental difference and source of tension is the differing methodologies that lead to the
construction to the model. For example accounting systems are based on ratio analysis as opposed to
rigorous statistical techniques.