Statistics in Retail Finance

Badr MissaouiRoom 545, Huxley Building

Overview

In this course we will cover several important areas wherestatistics are applied to retail finance.This chapter provides

I An introduction to the course topics ;I Course assessment information.

Topics covered in Statistics in Retail Finance

This will be a highly applied course, looking at the application ofstatistical methodology within one business area : retail finance.The emphasise is on :

I How to use statistics for decision making andI How to interpret and communicate statistical results.

Overview of Retail Finance

I Retail credit and defaultI Risk and reward

Credit Scoring

I Credit scores and scorecardsI Log-odds score and logistic regressionI Selection bias and reject inference

Topics covered in Statistics in Retail Finance

Behavioural models

I Static behavioural modelsI Survival models in retail financeI Markov transition models

Regulatory and portfolio modeling

I Capital requirementI LGD estimationI Value at Risk capital charge

Topics covered in Statistics in Retail Finance

Course assessment

This course will be assessed completely on course work. Therewill be 2/3 separate projects.

All course work will be based on developing statistical modelsfor a portfolio of retail credit accounts. You will use the Rstatistical 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 retailcredit 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 investmentbanking.

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 usedto assess risk on credit line.

Types of retail credit

Mortgage loan Loan secured on a physical property.Credit card Credit availability with upper credit limit

and no fixed repayment plan.Personal loan Loan with fixed repayments over time. Se-

cured loans are based on physical pro-perty, car, etc.

Overdraft Credit limit available in current account fora 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 ?I Primarily, earning interest payments on loans.I Fees associated with lending (eg mortgage fees and

overdraft fees).I 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 ?I Primarily, the risk of the borrower not making repayments

on the loan on time. This called delinquency.I Ultimately, persistent delinquency resulting in default on

the loan.I Typically, three months of delinquency will be considered

default, at which time banks will attempt to recoveroutstanding amounts.

I Some time after default, following recovery attempts, theoutstanding amount on a defaulted loan will be written-offfor accounting purposes.

I 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 2.91%Second mortgage 1.79%Bank cards 6.91%Auto loans 1.92%

Source : S&P/Experian Consumer Credit Default indices

Retail credit - the main players

Retail Banks

I Provide the majority of mortgages and consumer credit.I Major retail banks are listed on stock exchanges.I Usually part of multinationals that also include corporate

and investment arms.

Credit card company

I These companies specialize in just providing credit cardsand do not handle any other retail finance business.

Student loans company

I Administers government-funded loans and grants in theUK.

Retail credit - the main players

Credit reference agencies - Credit bureaus

I Collect and provide data about individuals to informdecisions on providing credit.

I Provide data and services to retail banks.I UK credit bureaus : Experian, Equifax, CallCredit.

Pay day lenders

I These lenders that provide small loans over short periodsof time are becoming much bigger players in the UK creditmarket.

Regulators

I Protect the consumer and user of financial services.I Endeavor to provide stable financial markets, e.g. ensure

retail banks maintain sufficient capital reserves to back uploans.

I UK regulator :I The Financial Conduct Authority (www.fca.org.uk)I The Prudential Regulation Authority

(www.bankofengland.co.uk).

Summary

Statistical methods are used to estimate risk and reward forretail credit.In this course we consider all aspects of these risks andrewards.

I Models of delinquency and default ;I Estimates of probability of default (PD) ;I Estimates of profit on credit products ;I Expected loss estimates, taking default into account ;I Fraud detection.