Driving Growth with a New Measure of Credit Capacity

Driving Growth with a New Measure of Credit Capacity Driving Innovation FICO and Equifax Open Avenues to Growth with a More Comprehensive Approach to Risk Assessment August 2012 For more than five years, growth initiatives have been extremely difficult for UK lenders. In a weak, uncertain economy, even a modest amount of additional debt can push many consumers even those with favourable credit profiles into default. Today, when evaluating consumers for new loans or extensions of credit, lenders must measure repayment risk, and they must take another measure into account: How much credit is too much? That s why FICO and Equifax are helping UK lenders jump start growth with the combination of solid risk assessment of a consumer s historical and current obligations via Equifax s Risk Navigator score and a consumer s capacity to manage additional obligations via the new FICO Credit Capacity Index. The new index is a complementary risk measure that predicts capacity by inferring a consumer s ability to manage incremental debt not yet represented on the credit file. This paper describes the new Credit Capacity Index, how it s differentiated from other measures of capacity, and why it can help lenders profitably reignite growth when used as a complementary measure to the Risk Navigator score. The paper demonstrates the potential of the new score through: Validation testing, as well as how it can be effective in developing strategies when used with risk scores. A value analysis based on a champion/challenger strategy comparison between the use of risk scoring and the enhanced scenario incorporating the Credit Capacity Index. - 1 -

Introducing a New, Complementary Perspective on Risk UK lenders have by now successfully reduced loss rates by tightening credit policies. But that isn t a sustainable business model for growth. Now, with the recent introduction of a unique, additional measure of risk, one that complements today s other customer decisioning practices, UK lenders can begin to grow their portfolios with much greater protection from losses. Every participating party in the UK financial services industry, both lenders and regulators, recognizes today s fine line between profit and loss. Many credit holders even some with exemplary credit histories are at greater risk of default than in years past. Clearly, there s a shrinking, less distinctive margin between good and bad risk standing, making portfolio growth more challenging. Lenders are addressing this challenge in several ways but more can be done to stimulate meaningful growth. To comply with post-credit crisis regulations mandating better assessment of affordability, and fuelled by their own interests to prevent future losses, lenders have bolstered their strategies by digging more deeply into consumer data. Greater reliance on measures of income and debt ratios, and improvement in broad-based risk scores such as Equifax s Risk Navigator score have provided some lift in providing finer segmentation of good risks from bad risks. However, now UK lenders can significantly advance their consumer decisioning criteria with insight from a new and complementary measure: FICO Credit Capacity Index. FICO and Equifax Introduce the FICO Credit Capacity Index The UK alliance of Equifax and FICO is now offering a new risk assessment technology developed specifically for UK lenders. Based on credit history and performance data drawn from Equifax s market-leading bureau database, the FICO Credit Capacity Index provides a more complete picture of consumer credit risk. The new score is designed to work in tandem with, and to augment, traditional risk scores and underwriting practices. The Credit Capacity Index is unique in predicting how a consumer s risk level changes if he or she takes on more debt. As many lenders have experienced over the past five years, additional credit can push many apparently low-risk consumers into default. That has made it difficult for lenders to safely originate new loans or credit, or to extend additional credit to existing accounts. The question then becomes, how much new credit can the consumer manage? Will the extension of an additional amount of credit to a consumer result in a mutually satisfying boon between the lender and consumer, or an unforeseen problem? That s the question that Credit Capacity Index addresses. Credit Capacity Index is an empirically derived predictive measure that generates a score to rankorder a consumer s ability to take on additional debt safely. Using proprietary Future Impact Action Modelling, Credit Capacity Index predicts capacity by inferring consumer sensitivity to incremental debt not yet represented on credit bureau reports. The index is designed and optimized for use with Equifax s Risk Navigator score. While Risk Navigator provides a granular assessment of a consumer s risk profile reflecting current obligations, the Credit Capacity Index uses a 10-level scale to predict a consumer s capacity to take on incremental debt relative to other consumers within the same risk score band. FIGURE 1: Jack, Emily, and Harry: Three consumers with the same risk score, but different capacity. 80% Estimated default rate (within a given risk band) 70% 60% 50% 40% 30% 20% 10% 0% Jack: Low Capacity Emily: Medium Capacity Harry: High Capacity 0 250 500 750 1000 1250 1500 1750 2000... Balance change, in - 2 -

Figure 1 shows that FICO Credit Capacity Index is able to differentiate individuals within the same risk score ranges to further refine and improve credit decisions. Credit Capacity Index reveals that Harry s high capacity his greater ability to safely manage additional debt makes him a better candidate (i.e. less likely to generate losses) than Emily and Jack for additional credit facilities. In addition, because Credit Capacity Index provides a score for all consumers who have a Risk Navigator score, it surpasses the effectiveness of other indebtedness and affordability scores in the marketplace that only target highly committed individuals. With Credit Capacity Index, lenders can rank a total population of consumers in terms of their risk in managing an additional amount of debt. As a result, Credit Capacity Index is highly advantageous for building growth: It enables financial institutions to make lending decisions across complete populations and across the lifecycle that overlay risk with capacity. Lenders can now modify decisions above and below a chosen risk cut-off score to improve growth and risk objectives. Strategic and operational benefits With a credit capacity measure, UK lenders can fine-tune decision strategies previously based on the use of a risk score and other decision criteria, such as income and debt-ratio. Relying on a combination of scores Credit Capacity Index, Risk Navigator, and application or behaviour scores and other data-based criteria, lenders can develop enhanced decision trees to approve more or larger loans without increasing overall risk exposure. For example, trees can be developed using tiered, riskbased pricing or tailored loan/credit amounts assigned to specific segments. Adding Credit Capacity Index to lenders decision criteria can drive improved, more profitable decisions across a number of decision points: originations, matching products to customers, line increase or decrease programs, and cross-selling. FICO Credit Capacity Index can also drive operational benefits that add to the bottom line: Support for compliance reporting and audits by further demonstrating the institution s focus on affordability. Faster processing and decision making, boosting profit margins through time and cost savings and by speeding approval to win loans from competitors. Stronger customer satisfaction and corporate image through more responsible lending practices. Demonstrated advantages through validation testing Equifax and FICO conducted in-depth testing to validate the ability of Credit Capacity Index to help lenders improve risk assessment alongside use of traditional scores, and other measures. The remainder of this paper discusses: Results of testing to demonstrate how Credit Capacity Index correlates to default rates; and to demonstrate how the capacity measure, as an overlay to traditional risk assessment, improves risk analysis. Practical uses of Credit Capacity Index for lenders. The financial value of Credit Capacity Index through an in-depth example. The Proven Power of Credit Capacity Index The Risk Navigator score is a strong risk predictor, and thus a valuable tool within risk management strategies. Like all traditional risk scores, the Risk Navigator score predicts credit risk given current obligations not how the risk would change given a change in a consumer s debt load, which is where Credit Capacity Index comes into play. There are many reasons why different consumers are assigned similar Risk Navigator scores. For example, some with mild delinquency and low utilisation may receive the same score as those with no delinquency but high utilisation. These various credit profiles within the same score band represent different sensitivities to incremental debt, as shown in Figure 1, above. The hypothetical consumers on this chart have similar risk scores, which would suggest the same probability of default given current obligations, but they have different capacities to take on additional debt. - 3 -

Figure 2 demonstrates the differentiation by capacity across the risk spectrum. For example, in the 406 450 Risk Navigator score band, the total bad rate was approximately 6%, whereas the average bad rate for individuals with high FICO Credit Capacity Index scores in that band was only about 1%. Credit Capacity Index can help a lender identify these candidates, and the lender may elect to make an offer to the higher capacity consumers in lieu of the lower capacity individuals in higher Risk Navigator score bands. FIGURE 2: FICO Credit Capacity Index differentiates consumers within Risk Navigator score bands Bad rate (90+ DPD) 25% 20% 15% 10% 5% Credit Capacity Index by Risk Navigator bad rates - existing accounts, credit card Low CCI Medium CCI High CCI Total 0% Low-340 341-405 406-450 451-475 476-490 491-510 511-520 521-530 531-540 541-High Risk Navigator score Currently, many UK lenders attempt to achieve deeper consumer insights by overlaying various metrics to risk scores. For example, income figures or monthly debt service (MDS) ratio figures can be used in addition to risk scores to segment individuals within a portfolio. While these may be helpful in assessing a consumer s current financial situation, FICO Credit Capacity Index is extremely effective at finding additional segmentation within groups who otherwise might qualify for similar treatments in lenders existing credit strategies. For example, as shown in Figure 3, the total bad rate, shown by the red line, is relatively stable across various MDS groups, suggesting that MDS is not very predictive of risk. When MDS groups are overlaid with capacity, Credit Capacity Index identifies consumer segments with relatively high, moderate and low capacities to manage increased debt a unique insight into consumer capacity not captured by other segmentation approaches. FIGURE 3: FICO Credit Capacity Index differentiates between MDS measures Bad rate (90+ DPD) 25% 20% 15% 10% 5% Credit Capacity Index bad rate by Monthly Debt Service - new accounts Low CCI Medium CCI High CCI Total 0% Low-50 51-100 101-150 151-200 201-300 301-400 401-500 501-1000 1001-1500 1501-High Monthly debt service on fixed term loans, in - 4 -

Practical Applications of Credit Capacity Index So, how can UK lenders use FICO Credit Capacity Index in practice? The following explores a sample strategy for new bankcard accounts. Originations underwriting for many lenders involves use of strategies that include risk scores, income and other decision keys. Credit Capacity Index can be added to a lender s existing strategies, providing new information on consumer capacity not otherwise captured. Understanding capacity helps lenders fine-tune target offers and initial line assignments, especially near existing cut-off zones, as illustrated in Figure 4 where Credit Capacity Index is used in addition to other measures. FIGURE 4: Applying FICO Credit Capacity Index to originations decisions Very High Accept Maximum Line Application score, consisting of a risk score, income, and other criteria High Medium Decrease Line from Standard Assignment Standard Line Assignment Increase Line from Standard Assignment Low Decline/Accept Minimum Line While this sample strategy is somewhat basic, it demonstrates the overall approach for using FICO Credit Capacity Index: Consumers with very low or very high application scores would be treated the same as before, with few exceptions. Consumers with application scores in the lender s operating range or in borderline areas could be assigned either higher or lower lines, depending on capacity. For example, in the mid-risk score range, there may be opportunities to increase lines for high capacity consumers, but reduce total lines by the same amount when capacity is low. This would minimise future losses and maintain consistent exposure levels. Account Management Example Low CCI Med CCI High CCI FICO Credit Capacity Index A similar approach could be used in account management. Credit Capacity Index would be leveraged to enrich account management decisions alongside existing decision criteria, such as internal analytics, risk scores, current delinquency and relationship status. FIGURE 5: Identifying good growth prospects for cross-sell campaigns Risk Navigator score 406 to 450 - existing accounts, credit card Bad rate (90+ DPD) 16% 14% 12% 10% 8% 6% 4% 2% L - 45% M - 39% H - 16% Low CCI Medium CCI High CCI 0% 100 to 499 (35%) 500 to 1499 (32%) 1500 + (33%) Change in total balance in, by population (%) - 5 -

Figure 5 illustrates how a lender can use FICO Credit Capacity Index to safely and successfully improve profitability from existing accounts. Using a combination of Credit Capacity Index and Risk Navigator, a lender could identify a segment of high capacity individuals within a moderate risk score band (406 450). Without Credit Capacity Index, a lender might consider this score band too risky to consider cross-selling an additional credit offer. However, as Figure 5 shows, Credit Capacity Index is able to identify 16% of the accounts in the band as high capacity individuals, and 39% of the accounts in the band as medium capacity individuals. Given these individuals capacity measures, their risk is more equivalent to individuals in higher-scoring (lower risk) Risk Navigator bands. Conversely, lenders can apply Credit Capacity Index to build profitability by mitigating future losses. Figure 5 also identifies 45% of this score range as low capacity consumers, who are much more likely to default if they take on additional debt. A lender seeking to reduce overall exposure can use this insight to allocate capital towards those consumers who will generate positive revenues without resulting in charge-offs, or to shift capital from low capacity individuals towards higher capacity groups. Credit Capacity Index also highlights the increase amount at which low-capacity individuals exhibited degraded performance bad rates spike significantly among this group at greater than 1500 balance increase. Therefore, in addition to simply segmenting the group s individuals by capacity, the lender could also determine whether some low capacity individuals might be candidates for smaller line increases, or even for line decreases in some cases. In all strategies, it s important for lenders to remember that Credit Capacity Index is not a replacement for risk and other measures. After all, no lender would want to extend credit to high-capacity consumers who are also high risk. Just as a risk score s rank-ordering of consumers is only one contributor to credit extension strategies, Credit Capacity Index operates in much the same way. It serves as a key part of extension strategies by answering the question How much new debt can this consumer safely manage? Calculating the Financial Benefit of Credit Capacity Index Within strategies, Credit Capacity Index can enhance existing decisions by providing further rank ordering of consumers based on their capacity for incremental debt. The lender can then create more granular, tailored strategies based on capacity segments, expanding credit to consumers with high capacity and limiting credit to consumers with low capacity. With capacity as an additional input, lenders can define a challenger strategy built on swap sets of consumers who will be given different treatments under the challenger strategy versus the existing, champion strategy. To help determine the financial value that Credit Capacity Index can deliver, let s consider a value calculation based on validation results from a UK credit card portfolio, performed on the development data sample. The objective of evaluating the line management strategy is to improve the allocation of capital. This means that some segments may receive a line increase in order to promote utilisation and balance build, while others may be restricted to minimise potential loss. Overall, a similar level of exposure is maintained in both the champion strategy and the challenger strategy incorporating Credit Capacity Index. The analysis assumes a population of 1,000,000 accounts, of which 810,000 are the eligible accounts based on a set of decision keys, such as accounts being active and on the books for longer than 12 months, having no delinquencies, and passing reasonable criteria and score cut-offs for utilisation, behaviour and risk score, as illustrated in Figure 6. In the champion strategy, the cut-off for receiving a line increase was Risk Navigator 476, in order to keep the bad rate below 3% on the increased lines. Line increases started at 500 and increased for higher score bands, as shown below. Under this strategy, 48% of accounts qualified for an increase. - 6 -

FIGURE 6: Champion strategy for line increases DECISION KEYS Status Active & On Books for > 12 Months & Current Behaviour score Low Med-High Utilisation Low Med High Risk Navigator 476-490 491-510 511-520 521+ ACTION No action No action 500 CLI 1000 CLI 1500 CLI 2000 CLI No action FICO Credit Capacity Index further segments the population within each risk band into more granular groups based on capacity, as show in the matrix in Figure 7. For example, in Risk Navigator score band 451-475, where the overall bad rate is 3.56%, Credit Capacity Index identifies bad rates ranging from 13% at the lowest capacity level to less than 1% at the highest level. Within the higher scoring Risk Navigator bands, there are opportunities to limit or reduce credit lines, based on the individuals having low capacity. The red cells are the consumers to be swapped out; that is, the lender could decide not to give them a line increase at all, or could give them a smaller increase than their higher capacity peers. As shown in the blue area, there are also significant opportunities to extend line increase treatments into Risk Navigator bands that normally would be considered too risky to qualify, by targeting only the high capacity consumers. These are known as the swap in set. Depending on how aggressive a strategy or initiative is designed to be, the swap sets can be defined in various ways, either to expand the treated population and thereby grow the portfolio, or to limit risk and thus potential losses. FIGURE 7: Swap sets between champion and challenger strategies Bad Rate Matrix Risk Navigator Score Band Swap out-low capacity segment Score Cut-off Low-340 341-405 406-450 451-475 476-490 491-510 511-520 521-530 531-540 541-High TOTAL CCI 0 25.87% 18.66% 16.20% 13.33% 12.41% 12.11% 9.77% 9.79% 7.93% 9.33% 20.59% CCI 1 25.87% Swap 25.87% in-high 8.86% 7.01% 5.72% 4.95% 4.35% 3.35% 3.64% 4.34% 8.76% CCI 2 25.87% capacity 25.87% segment 5.78% 3.87% 3.29% 2.47% 2.00% 1.82% 1.49% 1.65% 4.89% CCI 3 10.16% 10.16% 4.08% 2.61% 1.90% 1.40% 0.91% 0.81% 0.65% 0.96% 3.02% CCI 4 8.35% 8.35% 2.92% 1.54% 1.09% 0.70% 0.48% 0.39% 0.37% 0.46% 1.79% CCI 5 6.42% 4.17% 2.03% 1.14% 0.83% 0.48% 0.34% 0.24% 0.17% 0.26% 1.01% CCI 6 4.16% 2.95% 1.40% 0.77% 0.53% 0.25% 0.17% 0.13% 0.08% 0.09% 0.48% CCI 7 3.56% 1.91% 0.73% 0.42% 0.25% 0.13% 0.08% 0.11% 0.05% 0.04% 0.22% CCI 8 0.72% 1.38% 0.48% 0.17% 0.13% 0.09% 0.06% 0.05% 0.03% 0.03% 0.09% CCI 9 0.00% 0.17% 0.02% 0.06% 0.07% 0.04% 0.04% 0.02% 0.01% 0.02% 0.03% TOTAL 21.21% 9.99% 6.01% 3.56% 2.45% 1.57% 0.99% 0.71% 0.44% 0.39% 4.73% - 7 -

To summarize, the challenger used a stair-step strategy to overlay FICO Credit Capacity Index on top of Risk Navigator. This matrix approach enabled the identification of swap sets, that is, groups of consumers who are given a different treatment based on their capacity, as shown in Figure 7. The high capacity population in two score bands below the initial cut-off of 476 is swapped in and given a line increase, while the low capacity population above the cut-off is swapped out and not given an increase. Identifying swap sets enabled the challenger strategy to continue giving a line increase to most consumers scoring 476 and above, and to extend a line increase into lower risk score ranges, when warranted by the additional measure of capacity. The Results Figure 8 compares the results of the two strategies. It focuses on the swap set populations, since they illustrate where different decisions would be made. FIGURE 8: Financial impact of using FICO Credit Capacity Index Swap In: Champion no increase Challenger increase Swap Out: Champion increase Challenger no increase Net Impact Number of accounts 71,834 33,372 38,463 Bad rate 1.3% 7.9% -6.6% Number of Goods 70,887 30,740 40,147 Number of Bads 948 2,632-1,684 Average line increase amount 500 985 N/A Total Exposure 35,917,224 32,858,706 3,058,517 Incremental revenue 1,754,452 1,495,062 259,390 Incremental loss 379,000 2,124,341-1,745,340 Incremental profit 1,375,451-629,278 2,004,730 Total eligible population 810,000 PROFIT PER ELIGIBLE ACCOUNT 2.47-8 -

As demonstrated through the actual bad rate seen in each population, the challenger strategy is able to increase a set of lower risk accounts with risk scores below the initial cut-off, but with higher capacity as identified through FICO Credit Capacity Index. Conversely, the challenger strategy does not increase a set of higher risk accounts above the initial cut-off, due to their low capacity. In order to maintain a conservative strategy, the total exposure given in the two strategies remains similar. To assess the profit potential, we use the following assumptions: 1) future good accounts will utilise 33% of the additional credit line offered, and the yield on that utilised credit will be 15%; 2) future bad accounts will utilise 80% of the additional credit line offered. That is, for every 500 additional credit offered, this translates into 24.75 in revenue from a good account and 400 in losses from a bad account. Note: for the sake of simplicity and conservatism, it is assumed that every 500 given yields the same incremental revenue, though experience shows that incremental revenue may diminish with higher line increases as consumers use less of the available credit given. The issuer in the above example would have realized a significant increase in profits from adopting the challenger strategy. Figure 8 shows that based on the assumptions above the issuer could generate additional profit of 2.47 per eligible account using a strategy based on a combination of Risk Navigator and Credit Capacity Index whilst keeping all other factors the same. For an annual line increase program applied to a portfolio of 1 million accounts, the challenger strategy could generate additional profit of up to 2 million. Conclusion No lender can wait for a strong enough economic rebound to help revitalize portfolio growth and profitability. The challenge is to compete effectively today, in current conditions. Loss reduction efforts are only part of the equation for success. What s the other part of the equation for growth today? Better, or additional, insight into capacity. A powerful capacity measure incorporates a consumer s ability to safely manage additional debt a forward-looking assessment which is particularly important in a lender s efforts to drive growth. At the same time, lenders need a highly granular assessment of a consumer s overall risk profile an historical assessment based on strong insight into historical performance data. FICO and Equifax are now giving UK lenders that depth of risk assessment with the new FICO Credit Capacity Index, working in conjunction with Equifax s Risk Navigator score. Lenders can now quickly attain a new level of risk assessment to more confidently begin to grow their portfolios in terms of adding new accounts and boosting lending volume and their profitability. Information: Telephone +447947 688124 Email enquiries@efxfico.com Web FICO and Credit Capacity Index are trademarks or registered trademarks of Fair Isaac Corporation in the European Community or the United States. Other product and company names herein may be trademarks of their respective owners. 2012 Fair Isaac Corporation. All rights reserved.