A timely development in the context of the current financial crisis is the proposal to develop an International Organization for Standardization (ISO) Standard on consumer credit scoring. The proposal was submitted by Austrian Standards, the ISO member for Austria.

Consumer credit scoring has been the subject of much debate. But the Basle II^* international regulations on bank's capital requirements made it an obligatory part of the process for obtaining retail credit.

Consumer rights advocates and market participants have criticised existing consumer credit practices because of their central role in the USA subprime crisis.

There is a growing need to define and specify the quality of credit scoring methods and processes, including the credit score itself with its data foundation and associated scales.

Quick, inexpensive, and objective?

Lenders use consumer credit scoring to determine who qualifies for a loan, at what interest rate, and with what credit limits. Consumer credit scoring is used by banks, credit card companies, mail order businesses, insurance companies, collection agencies, telecommunication providers, utilities, employers, and government agencies. It has become widespread and popular with lenders, as it allows a quantifiable credit assessment quickly, inexpensively, and objectively.

Although there will be some debate on how to standardise credit scoring, bank regulators included in the Basle II framework set of regulations for retail credit scoring (focusing on the forecasting abilities and robustness of credit scoring models). Elements of these regulations, imposed by data and consumer rights protection agencies, as well as voluntary commitments by credit score users, should be taken into account in the proposed ISO Standard.

Overall, international standardisation in this area is expected to foster transparency, clarity, comparability, and openness of methodologies, as well as impartiality and other ethics-based principles.

On par with progress

The aim is not to lay down uniform, constant, and immutable credit scoring criteria, statistical methods, and processes. Rather, there should, and will be, some variety in processes, systems, criteria and weightings, models, and measurement methods, taking into consideration rapidly changing credit markets, process challenges, and technologies.

Similarly, the proposed Standard does not intend to elevate a single model as the 'one and only', but be open to the innovative solutions that may be identified through research and development of academics and practitioners in the future.

The objective is to ensure that the quality of each consumer credit scoring method can be assessed in a standardised way by measuring the forecast power, precision, and robustness of the model. A standardisation of minimum requirements would be developed for objectives, scoring objects, predicted credit events, forecast horizons, data records underlying the statistical analysis, portfolio definitions, score values and classes, transparency of the methodology, documentation, and staff training.

The proposed Standard would then help prevent the emergence of methods and processes driven by interests that are untrustworthy or false, or that are able to manipulate the retail credit markets as a result of failures in accreditation or auditing systems. The market requires such a minimum level of quantifying criteria for professional credit scoring services, in order to distinguish these from mere expressions of opinion. Declarations of voluntary commitment alone are probably insufficient to the market and do not foster competition for professional credit scoring services.

The proposed Standard would look only at consumer credit scoring, and will not address rating, which refers to the assessment of creditworthiness in a broader sense, not restricted to statistical formulas, and subject to human judgement.

The work is expected to start at the end of 2009, pending formal approval.

* Basle II is the second of the Basle Accords, which are recommendations in banking laws and regulations issued by the Basle Committee on Banking Supervision. Basle II sets rigorous risk and capital management requirements to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices.

Reproduced from an article by Dr Holger Muehlbauer in ISO Focus, July-August 2009.