One of the crucial steps of the score development is determining the bad definition. You already have an “ultimate bad definition”: This is what you want to predict specifically. In different environments the ultimate definition will vary, but here I’ll examine the most common one, which is defaulting.
Whether the customer defaults or not is a binary information, 0 if the customer is good (not defaulted) and 1 if the customer is bad (defaulted). However in most cases, the percentage of portfolio that defaults in a short time frame is very low, i.e. the meaningful default rate occurs in a late stage of product lifetime. Therefore you need to develop a definition that will predict this default rate. An example:
Bad: Ever missed payment for 60 days within the next 12 month frame or has a payment that is 30 days past due in the end of 12th month from now.
Good: Never missed payment for 60 days within the next 12 months and does not have a payment above 30 days past due in the end of 12th month from now.
Also in some cases, you may want to distinguish your goods and bads even further. This is when you develop also the indeterminate definition, which are neither very good nor very bad. Later by excluding these customers, you will be able to have a much more distinguished good customers and bad customers, therefore your good/bad odds will be higher.
The use of indeterminate definition depends on the separation that comes from your performance definition analysis.
Performance Definition Analysis
Group the accounts according to their initial time frame performance, then check each group’s post-period performance. See below for the example (click the picture to see larger):
Eop: End of period. — dwp: # days with missed payment.
We first accepted that our ultimate goal is to predict the definite bads (charged-off customers) or definite goods (totally paid off). As seen in the figure, if we see customers who ever hit 90 days without payment in their first 12 months or if we see customers who will be off-payment for 60-89 days in the end of the period of 12 months – they will be most likely to go full charge-off in the next 12 months.
On the contrary, the customers who do not have any missed payment in the end of 12 months or at least have missed less than 30 days, they are also very likely to stay current (no missed payment) in the next 12 months.