Reexamining the Use of Economic Indicators in Consumer Credit Risk Management

By Liu, Jiong; Xu, Xiaoqing Eleanor | The RMA Journal, June 2010 | Go to article overview

Reexamining the Use of Economic Indicators in Consumer Credit Risk Management


Liu, Jiong, Xu, Xiaoqing Eleanor, The RMA Journal


With tightened regulations, declining credit quality, and an expected reduction in financial industry profit margins, consumer credit risk management has become even more important, especially for unsecured credit card portfolios. This study uses quarterly data from 1985 to 2009 to develop a powerful predictive model for the quarterly change in the credit card charge-off rate.

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Over the past 25 years, the U.S. has seen tremendous growth in consumer credit, especially revolving consumer credit such as credit card loans.

From the first quarter of 1985 to the second quarter of 2009, consumer credit outstanding increased to $2.48 trillion from $536 billion. Over the same period, revolving consumer credit outstanding increased to $904 billion from $107 billion (Figure 1). The 9.6% annual growth in revolving consumer credit is much higher than the 6.27% annual growth in nominal GDP over the same period.

Along with this exponential growth in revolving consumer credit is an astonishing increase in the credit card charge-off rate, which rose from 1.99% in the first quarter of 1985 to a record 9.55% in the second quarter of 2009 (Figure 2). Over the past 25 years, the charge-off rate on unsecured credit card loans has averaged four times the charge-off rate on other consumer loans and 10 times the charge-off rate on real estate loans.

Given the growing size of revolving consumer credit and the alarming deterioration in consumer credit quality, consumer credit risk management has become increasingly important, especially for financial institutions issuing credit cards. Typically, credit risk management practices include risk-based account origination, interest rate and fee setting, credit line management, balance transfer, and so on. These practices generally use credit bureau scores or in-house credit-scoring models to tie the interest rates, fees, and credit limits of credit card accounts to the creditworthiness of the cardholders.

The recent passage of the Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (Credit CARD Act), which substantially expands cardholder protections and issuer obligations, has made it much harder for financial institutions to use traditional risk-based pricing to manage the credit risk exposure of credit card portfolios. (1) This highlights the importance of more macro-oriented strategic credit risk management practices.

The predictive power of economic indicators for commercial credit risk has been examined in corporate bond literature (Fridson, Garman, and Wu 1997, Carey 1998, Bangia, Diebold, and Schuermann 2000, Nickell, Perraudin, and Varotto 2000, and Crouhy, Galai, and Mark 2001) and recognized in the commercial credit rating system by S&P, Moody's, and Fitch. In the consumer credit risk management area, credit risk scoring is the most common practice in quantifying consumer risk and predicting specific performance outcomes, such as a consumer's probability of delinquency or default within a certain period of time.

FICO risk scores are provided by three national credit bureaus in the United States--Equifax, TransUnion, and Experian--using an advanced predictive model developed by Fair Issac. In addition to these industry-wide FICO scores, credit card lenders often use both credit bureau data and additional in-house consumer information in developing in-house customer risk scores (Nelson 1997 and Mays 1998, 2004). The recent financial crisis of 2007-08, which was largely due to the failure of credit risk management in consumer lending, has clearly revealed the insufficiency of credit-scoring tools in credit risk assessment and management (Thomas 2010). While credit-scoring models recognize the differences in credit quality among various consumers, they fail to recognize that the probability of default is highly dependent on economic conditions.

In an article published in the September 2003 issue of The RMAJournal, we first examined the use of key economic indicators in consumer credit risk management, with a special focus on unsecured revolving consumer credit in the form of credit card loans. …

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