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Statistics in Retail Finance

Badr Missaoui
Room 545, Huxley Building

Overview

In this course we will cover several important areas where


statistics are applied to retail finance.
This chapter provides
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An introduction to the course topics ;

Course assessment information.

Topics covered in Statistics in Retail Finance


This will be a highly applied course, looking at the application of
statistical methodology within one business area : retail finance.
The emphasise is on :
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How to use statistics for decision making and

How to interpret and communicate statistical results.

Overview of Retail Finance


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Retail credit and default

Risk and reward

Credit Scoring
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Credit scores and scorecards

Log-odds score and logistic regression

Selection bias and reject inference

Topics covered in Statistics in Retail Finance

Behavioural models
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Static behavioural models

Survival models in retail finance

Markov transition models

Regulatory and portfolio modeling


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Capital requirement

LGD estimation

Value at Risk capital charge

Topics covered in Statistics in Retail Finance

Course assessment
This course will be assessed completely on course work. There
will be 2/3 separate projects.
All course work will be based on developing statistical models
for a portfolio of retail credit accounts. You will use the R
statistical language to perform data analysis.

Topics covered in Statistics in Retail Finance

Recommended textbooks
1. Thomas, Lyn C. (2009)
Consumer Credit Models : Pricing, Profit and Portfolios,
OUP.
2. Anderson R. (2007)
The credit scoring toolkit : Theory and practice for retail
credit risk management and decision automation, OUP
3. Thomas L. C., Edelman D.B. and Crook J.N. (2002)
Credit scoring and its applications, SIAM, Philadelphia.

Retail Finance : an overview


Retail finance consists in providing financial services to people.
It is a branch of finance distinct from corporate or investment
banking.
Typical retail finance services :
1. Deposit accounts and payment services ;
2. Credit cards ;
3. Personal loans ;
4. Mortgages ;
5. Insurance.
In this course, we will focus on the credit/lending services,
since this is where statistical methods are predominantly used
to assess risk on credit line.

Types of retail credit

Mortgage loan
Credit card
Personal loan

Overdraft

Loan secured on a physical property.


Credit availability with upper credit limit
and no fixed repayment plan.
Loan with fixed repayments over time. Secured loans are based on physical property, car, etc.
Credit limit available in current account for
a fee and usually a limited duration.

Risk and Reward of Credit

Lenders aim to maximise reward with minimum risk.


What are the rewards of lending ?
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Primarily, earning interest payments on loans.

Fees associated with lending (eg mortgage fees and


overdraft fees).

Establishing customer loyalty to sell products in the future.

Risk and Reward of Credit


Lenders aim to maximise reward with minimum risk.
What are the risks involved with lending ?
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Primarily, the risk of the borrower not making repayments


on the loan on time. This called delinquency.
Ultimately, persistent delinquency resulting in default on
the loan.
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Typically, three months of delinquency will be considered


default, at which time banks will attempt to recover
outstanding amounts.
Some time after default, following recovery attempts, the
outstanding amount on a defaulted loan will be written-off
for accounting purposes.

Fraudulent use of credit that results in losses.

How common is consumer default

Default rates in USA (October 2010) :


%age of accounts in default (per annum)
First mortgage
Second mortgage
Bank cards
Auto loans

2.91%
1.79%
6.91%
1.92%

Source : S&P/Experian Consumer Credit Default indices

Retail credit - the main players


Retail Banks
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Provide the majority of mortgages and consumer credit.

Major retail banks are listed on stock exchanges.

Usually part of multinationals that also include corporate


and investment arms.

Credit card company


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These companies specialize in just providing credit cards


and do not handle any other retail finance business.

Student loans company


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Administers government-funded loans and grants in the


UK.

Retail credit - the main players

Credit reference agencies - Credit bureaus


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Collect and provide data about individuals to inform


decisions on providing credit.

Provide data and services to retail banks.

UK credit bureaus : Experian, Equifax, CallCredit.

Pay day lenders


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These lenders that provide small loans over short periods


of time are becoming much bigger players in the UK credit
market.

Regulators

Protect the consumer and user of financial services.

Endeavor to provide stable financial markets, e.g. ensure


retail banks maintain sufficient capital reserves to back up
loans.
UK regulator :

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The Financial Conduct Authority (www.fca.org.uk)


The Prudential Regulation Authority
(www.bankofengland.co.uk).

Summary

Statistical methods are used to estimate risk and reward for


retail credit.
In this course we consider all aspects of these risks and
rewards.
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Models of delinquency and default ;

Estimates of probability of default (PD) ;

Estimates of profit on credit products ;

Expected loss estimates, taking default into account ;

Fraud detection.