Chapter 3 – Credit Scoring

Credit Scoring — Concepts:

The interest rate charged to a customer depends on the risk perception of the customer by the bank. Banks include risk premium in interest rates. The risk perception is different for different borrowers and, ideally, should be determined from their credit history. The lending bank can judge how good a borrower can be by sourcing their credit score from different agencies.

Credit Score:

Credit Score takes a look at the customer’s credit report and through advanced analysis turns the information into a 3-digit number which represents the risk associated with that particular customer transaction. The higher the score, the lesser is the risk of the consumer’s account becoming overdue. In US Credit scoring is done since 1989, when the FICO scores were launched. The lines of credit assessed to arrive at this score would mainly be retail products like home loans, auto loans, personal loans, credit cards and overdrafts.

Evolution of Credit Scoring:

 In today’s environment, when there is a pressure for growth of credit, banks are lending to lower income groups. This calls for sophistication to accurately assess borrowers’ ability to repay and, also, to correctly price the loan. For this, banks require assistance of credit information companies who provide a comprehensive report on every retail credit customer containing their verified address, the extent of loans they have taken and whether or not they have ever defaulted or failed to repay any loans on time and in full.

Global experience shows that managing risk and knowing retail loan customers is important for business. For example, in South Korea and Hong Kong, there were very high defaults in retail loans and credit cards. In the U.S.A, three credit bureaus viz. Trans Union, Equifax and Experian provided the credit score for retail customers.

A Credit bureau tracks the indebtedness and repayment history of individual borrowers on loans they have taken from banks, non-banking financial service companies and financial institutions. It also contains certain personal information of each borrower, like name, age and verified permanent address. The information is collected in a credit information report, which is made available to loan-issuing members. The credit information bureaus broadly use the following weightages given below to arrive at the score.

• Payment History – 35%;
• Amounts Owed – 30%;
• Length of Credit History — 15%;
• New Credit – 10%;
• Types of Credit in Use —10%

What is a Good Credit Score:

In the US, a FICO score of more than 700 is considered excellent. Whether a score is good or not will depend on the bank’s internal policy, its customer profile and its risk appetite. Still, any score over 800 will be considered excellent across the board. The credit score is only an indicative tool for managing risk and its effectiveness depends on the banks’ internal control mechanism. An objective thing like the credit score will not only help the banks to reduce defaults but also make loan disbursing faster, improve operational efficiency and bring costs down.

Credit Scoring Model:

The scoring model used by CIBIL-Trans Union employs multiple attributes including

• Credit Utilisation
• Payment History.

Credit Utilisation means how much credit is being used by the customer. If a customer could borrow Rs 1 lac but is actually borrowing. Rs 50,000, then he is a very safe person from lender’s point of view. It also means that he is not overleveraging.

Payment history includes whether there has been a default by customer. If there has been a default, then on how many accounts defaults occurred, by how many days and by_how much. A good repayment history can offset the blemish of a default due to unforeseeable reasons.

Managing the Credit Score:

• Credit Utilisation: If a person’s safe limit is Rs 10000 and he is using only Rs 5000, then he is a very safe customer. If a person’s limit is Rs 10000 and he is not fully using it, but also seeking further credit, he could be overleveraging himself and his score could fall. The high number of enquiries, application for additional credit lines, unnecessary and frequent shopping for credit or too many new accounts can be taken as an indicator of being over-hungry for loans and impact the score negatively.
• Payment Defaults: Number of overdue accounts, number of days for which overdue and how much amount is overdue will affect credit rating.
• Trade Attributes: Credit score is also affected by age of line of credit, type of line of credit, mix of various lines of credits. A history of consistent repayment of various types of credit will improve the score.

Positive side of Credit Score:

A good credit score will indicate the character of the borrower in his financial matters. The following are some of the indicators of good score.

• Evidence of financial discipline.
• If the borrower has defaulted once or twice due to reasons beyond their control, those would show up as clear aberrations in an overall consistent payment history.
• The longer the credit history, the better. The lender’s assessment improves as the span of repayment is bigger.
• The score normally ranges between 300 and 900. A score of 800+ is considered as a good score but this may vary from bank to bank.

Warning Signs in Credit Score:

Craving for credit. Frequent and unnecessary shopping for credit. Several new accounts or recent requests for loans can be taken as signs of an over-hungry borrower. Trade attributes — if there is not a good mix of credit. The above activities will bring down the credit score. Therefore, borrower should maintain financial discipline, repay dues on time and should not over leverage himself. In India, earlier one could not know his credit score. Now RBI has advised that a copy of credit information report be made available to borrower also on payment of fees of Rs 50.

Credit Scoring Bureau in India:

• The first credit bureau in the world, Dun & Bradstreet, (a shareholder in CIBIL) was set up back in 1841. In India, Cibil, in a tie-up with TransUnion of the US, launched the first credit information company. Fair lssac Corporation has started in a tie-up with High Mark Credit Information Services, and Equifax in association with Crisil and Tata Capital. In addition, Experian credit information company has also started.
• Credit Information Bureau of India Limited (CIBIL) is a privately owned company, which collects credit information on over 140 million credit card holders and loan takers. CIBIL is India’s first credit information bureau. This credit information bureau was formed on the basis of recommendations of a working group constituted by RBI.
• The company was originally promoted by the State Bank of India (SB1), Housing Development Finance Corporation Limited (HDFC), Dun & Bradstreet Information Services India Private Limited (D&B) and TransUnion International Inc (TransUnion). Now number of banks hold equity in CIBIL. Tansunion has equity of 19.99%. All other members have equity up to or less than 10% each. It helps banks, financial institutions and other financiers to share credit histories of retail and commercial customers. The bureau provides both positive and negative information about bank’s borrowers, which empowers lenders in assessing the credit worthiness of potential customers. CIBIL shares a relationship with all banks based on the concept of sharing. They collate the credit information available from all financing institutions, which are its members, and provide an informed report, which takes into consideration all the financial activities of a consumer when asked for by the bank. CIBIL works mainly on the concept of reciprocation. Therefore, only those banks, which share all their customers credit information with them will be given access to the credit reports that CIBIL has. CIBIL’s primary job is to collate data on the credit worthiness of all borrowers from banks and prepare customer information reports (CIR) to help credit grantors make faster and more objective lending decisions.

Issues in Credit Scoring:

• Credit scoring enables banks to assess the risk based on the score and accordingly decide the price for the risk.
• Credit Scoring enables banks to speed up credit decisions and disbursement based on the score. Responsible customers can expect faster and more competitive services at better terms and rates from banks and other credit companies.
• Based on Customer Information Report (CIR), the credit bureau would assign a credit score to every potential borrower which would bring about the differentiation in rates.
• A person can access his credit reports directly by putting in a request to CIBIL directly and if any errors are found, one can notify the bank and CIBIL regarding the same. The customer may get score but its basis is not available. The name of a willful defaulter will remain on the list for at least 7 years during which getting a credit card or loan is virtually impossible.

Mistakes in Credit Scoring:

1. Confusion of Names: There can be lakhs of names that are similar in the CIBIL database. Things can go haywire if a person with same name has defaulted and all his defaults get recorded in other’s file.
2. Human Input Error: The information that goes from the banks to the CIBIL on a default may have been erroneous due to simple input error by one of the bank employees.
3. Identity Theft : This is the most serious of all causes of errors and can have a disastrous impact on a person’s credit profile. In recent times, identity thefts are on the rise. Right from a petty shopkeeper who swipes your card several times to sneak in an unofficial payment or track credit card details, which he can exploit, to a terrorist who wants to access a billionaire’s account in a remote corner of the world, identity theft is becoming a serious crime that needs check.

Troubleshooting Credit Score: The following steps may be taken for seeking clarifications in credit report:

• Contact the bank that declined a credit card or loan application on the basis of your poor credit score.
• The bank will provide you with the control number of the credit report and also share the information on the credit report that is responsible for your poor credit score.
• The control number is a nine digit unique number that helps CIBIL track an individual’s credit report from its database. The control number is generated when banks pull out your credit report on a requirement basis.
• The control number is a unique number, which is generated every time any bank or credit institution pulls out a credit report on you.
• CIBIL requires this number to enable them to view the exact details that the bank has seen when they drew a report on you.
• Clarify your position to CIBIL informing CIBIL control number and the exact nature of the discrepancies in the report.