 |
|
Credit Risk Analysis All Articles • Home |
A Few Comments About the Limitations of Credit Scoring
By Michael C. Dennis MBA,
CBF
The theory behind credit risk scoring software is that the existence of certain risk factors, or combinations of risk factors, will result in a greater likelihood of serious payment delinquency or payment default. The stated advantages
-
Faster decisions.
-
More consistent decisions.
-
Better decisions resulting in increased sales and profits.
-
Increased productivity in the credit department.
-
The ability to identify customers that can be offered higher credit limits at relatively low risk to the company.
-
Flexibility built into the model so that the credit manager can alter certain parameters and increase or decrease the amount of credit risk the scoring model will consider acceptable, or unacceptable.
Much has been said and written about the advantages and benefits of credit scoring applied to commercial credit risks, but little has been written about the limitations of credit scoring models. Here are a few comments about the problems, limitations and disadvantages of credit scoring models:
-
A properly designed credit scoring system allows creditors to evaluate thousands of applications consistently, impartially and quickly. If this is true, then the opposite must also be true. A poorly designed credit scoring system can evaluate thousands of applicants and can make the wrong recommendation every time.
-
Credit risk can never be measured precisely, and any model that says it can is wrong.
-
Credit risk can change almost overnight. Example: The owner of a business dies and there is no one qualified to replace him.
-
Credit managers should be able to override the credit score and its credit recommendation. However, doing so is difficult to justify if there is a serious payment problem, or worse a bad debt loss. For this reason, credit professionals are reticent to override the scoring model even when they believe the "recommendation" is wrong.
-
Internally developed credit scoring models often lack sophistication and usually have not been subjected to critical analysis of the statistical significance of the factors used to develop a credit score and a credit recommendation...but
-
Professionally designed, tested and validated credit scoring models can be expensive, and can be hard to customize. As a result, the credit scores these programs generate may not mimic the decision making style and the risk tolerance of the companies that purchase them - and therefore they do not produce the desired results.
-
Some professionally designed models only provide the credit manager with a numerical score. With this limited information, it can be quite difficult for the credit manager to explain a negative credit decision [based only on a numerical score] to an irate credit applicant, or to an active customer.
|
Business Credit Articles |
