From Credit Scoring to Regulatory Scoring: Comparing Credit Scoring Models From a Regulatory Perspective

Abstract

Conventional credit scoring models evaluated by predictive accuracy or profitability typically serve the financial institutions and can hardly reflect their contribution on financial stability. To remedy this, we develop a novel regulatory scoring framework to quantify and compare the corresponding regulatory capital charge errors of credit scoring models. As an application of RegTech, the proposed framework considers the characteristic of example-dependence and costsensitivity in credit scoring, which is expected to enhance the ability of risk absorption of financial institutions and thus benefit the regulators. Validated on two real-world credit datasets, empirical results reveal that credit scoring models with good predictive accuracy or profitability do not necessarily provide low capital charge requirement error, which further highlights the importance of regulatory scoring framework. The family of gradient boosting decision tree (GBDT) provides significantly better average performance than industry benchmarks and deep multilayer perceptron network, especially when financial stability is the primary focus. To further examine the robustness of the proposed regulatory scoring, sampling techniques, cut-off value modification, and probability calibration are employed within the framework and the main conclusions hold in most cases. Furthermore, the analysis on the interpretability via TreeSHAP algorithm alleviates the concerns on transparency of GBDT-based models, and confirms the important roles of loan characteristics, borrowers’ solvency and creditworthiness as powerful predictors in credit scoring. Finally, the managerial implications for both financial institutions and regulators are discussed.