QUESTION
We want to develop our own credit scoring system as part of a new loan
product roll-out. We could use some guidance on how to get started. Our
question is, what do we need to consider in developing our own credit scoring
system?
ANSWER
Let me premise my response by stating that developing a credit scoring system reaches many
regulatory guidelines and interlocking regulatory frameworks and rules. Unless
you have highly competent legal and regulatory compliance support, I urge you
not to undertake such a formidable task. If you came to us for guidance, we
would need to know quite a bit not only about the new loan product but also your
company’s loan origination process as it relates to your other existing loan
products. In other words, you should not review a proprietary credit scoring
system as an isolated matter.
However, I will offer some pointers for an initial point of departure.
To begin, you might want to start with the Equal Credit Opportunity Act
(ECOA). The ECOA sets forth two methods to evaluate applications (for ECOA
purposes): (1) “empirically derived and other credit scoring systems,” and (2) “judgmental
systems of evaluating applicants.” The former terminology is meant to refer to
an objective method, while the latter is meant to refer to a subjective method.
It is not a requirement to use either methodology, but, as a practical matter,
creditors tend to use one of these methods or, in some cases, a combination of
the two methods. If two methods are combined, regulators will treat the
combined method as a judgmental system. I am not sure which method, or
combination thereof, that you plan to develop. For the sake of an abbreviated answer
here, I will call the first method “Empirical” and the second method “Judgmental.”
Essentially, an Empirical system contains two elements: (1) a credit
scoring system, and (2) a means to derive data that is empirically derived as
well as demonstrably and statistically sound. Determining what is and is not
creditworthy, especially in a mechanical evaluation based on key attributes of
the applicant and aspects of the transaction (which is the case in Empirical
systems), is a deep dive undertaking. [See 12 CFR § 202.2(p)(1)] Be prepared to be
challenged by a regulator, where you will need to show that your Empirical
system provides at least the following four qualifications:
1. The system is based on data derived from an empirical comparison of
sample groups or the population of creditworthy and non-creditworthy applicants
who apply for credit in a reasonable preceding period of time;
2. Your company developed the system for a legitimate business purpose;
3. Acceptable statistical principles and methodology are used to develop
the system; and,
4. There is a periodic, tracked sequence of revalidation of the
statistical elements and methods, with adjustments (as needed) to maintain
predictability.
I suggest that you review Regulation B and its Commentary – Regulation
B is the implementing regulation of the ECOA – for additional guidance on the
development, validation and revalidation of an Empirical system, whether yours
or one obtained from another party. [12 CFR § 202.2(p)(2); 12 CFR
Supplement I to Part 202, Official Staff Interpretations §
202.4(b)-1]
A Judgmental system is any system for evaluating the creditworthiness
of an applicant other than an Empirical system. [12 CFR § 202.2(t)] That is, if the proposed
Empirical system does not qualify as an Empirical system, the proposed system
is a Judgmental system as far as the ECOA is concerned. In a Judgmental system,
a “pertinent element” is applied, which is any information about applicants
that a creditor obtains and considers that has a demonstrable relationship to a
determination of creditworthiness. [12 CFR § 202.2(y)]
For instance, in a Judgmental system a creditor may consider an applicant’s age (or whether an applicant’s income is derived from any public assistance program). Each of these is a factor affecting an applicant’s creditworthiness. But utilizing this kind of factor is exactly why I urge caution in trying to develop a credit scoring system without expert guidance. A factor can be a negative factor, too. In relation to the age of elderly applicants, a negative factor means the system utilizes a factor, value or weight in a less favorable way regarding elderly applicants than the creditor’s experience warrants or is less favorable than the factor, value or weight assigned to the class of applicants that are not classified as elderly and are most favored by a creditor on the basis of age. [12 CFR § 202.2(v)]
Jonathan Foxx, PhD, MBA
Managing Director
Lenders Compliance Group
