Transaction_Scoring - WVK MasterCard

Transaction_Scoring - WVK MasterCard

• 1.
  U.S. Insights August 2011ADVANCINGINSIGHTS ADVANCING COMMERCE. TRANSACTION SCORING: WHERE RISK MEETS OPPORTUNITY U.S. card issuers, broadly speaking, are employing risk management techniques developed during a time of growth. These techniques need significant enhancement, given issuers’ current lack of liquidity as well as a more conservative and cautious consumer population. Transaction scoring can increase the predictive accuracy of risk management by identifying risky behavior in real time, while simultaneously reducing false positives. This technique enables issuers to intervene in accounts earlier and with greater precision, providing a wider range of options in terms of next steps. New technology in form factors, like mobile, make real-time intervention a reality. Using transaction scoring as a component of credit risk management also allows issuers to guide account holders into more responsible use of credit. Transaction scoring in conjunction with existing models can deliver lifts of 10 to 15 percent in Kolmogorov-Smirnov (KS) tests over traditional scores alone.115% Executive Summary U.S. issuers face a daunting challenge: Finding growth opportunities in an industry that is being buffeted by contraction and constraint. Transaction scoring—the use of real-time transaction data in scoring for credit risk—can increase the predictive accuracy of risk management by creating account-level variables that identify patterns of behavior in real time. Using transaction scoring helps issuers see more deeply and clearly into their customers’ behavior, resulting in more precise, measured, and responsible treatment of risk. The benefits of transaction scoring extend beyond risk management to identifying opportunities. By reducing false positives, transaction scoring can provide greater visibility into positive or neutral use of credit cards, which issuers can leverage in cross-sell, up-sell, promotions, or product fine-tuning. Transaction scoring: • Is built on a foundation of industry best practices • Can assist institutions in more accurately pricing new exposures at origination, given Credit CARD Act limitations • Provides a benefit to both financial institutions and consumers by allowing issuers to more finely segment their portfolios and more accurately design interventions for each kind of account, risky or not The last point is especially important in light of current economic and regulatory conditions. Transaction scoring provides a true social benefit by keeping the banking system and payment networks open to as many consumers as possible. BY Westley Koenen and Theodore Iacobuzio
• 2.
  2 ADVANCING INSIGHTSADVANCING COMMERCE. U.S. Insights By creating account-level variables that identify patterns of behavior in real time, transaction scoring helps issuers see more deeply and clearly into their customers’ behaviors, resulting in more finely grained and actionable segmentation. NEW TIMES CALL FOR NEW MEASURES The challenge facing U.S. credit card issuers today is clear: How to expand a business that has undergone large-scale contraction. MasterCard believes that the use of transactional data in managing portfolio risk represents a significant opportunity—one that can play a major role in meeting this challenge. Transaction scoring, along with the proprietary techniques necessary to leverage the data in actionable ways, can increase the predictive accuracy of risk management. It does so by identifying risky behavior, reducing false positives and, importantly, making that information available earlier than is possible in traditional approaches. By creating account-level variables that identify patterns of behavior in real time, transaction scoring helps issuers see more deeply and clearly into their customers’ behaviors, resulting in more finely grained and actionable segmentation. The growth the industry experienced between 1992 and the crisis of 2008 is a matter of record. The U.S. credit card business grew at a compound annual growth rate (CAGR) of better than 10 percent from 1993 to 20072 and consistently delivered a 3 percent annual return on assets between 1992 and 2008.3 The contraction is also public information. Total consumer debt shrank $1 trillion, or 8.5 percent between October 2008 and the second quarter of 2011, as shown in Figure 1.4 In 2008, there were nearly six general purpose credit cards, excluding debit and private label, per U.S. household.5 By the end of 2010, each household had about four.6 Total credit limits (contingent liability) declined 26 percent, nearly $1 trillion, between June 2008 and the first half of 2011.7 In broad measure, of course, the deleveraging accomplished its goal. Credit card charge-off rates continue to decline—to above 8 percent in April 2011, down from a high of more than 13 percent a year prior (see Figure 2). FIGURE 1: Total U.S. Consumer debt outstanding (balances) have declined $1 trillion, or 8.5 percent, since October 2008 Total U.S. Consumer (Balances) Outstanding $10.6 $12.4 $11.3 4/06 12/06 8/06 4/07 12/07 8/07 4/08 12/08 8/08 4/09 12/09 8/09 4/10 4/11 12/10 8/10 13.0 12.5 12.0 11.5 11.0 10.5 10.0 $Trillions Source: Equifax, April 2011.
• 3.
  3TRANSACTION SCORING: WHERERISK MEETS OPPORTUNITY Transaction scoring represents a much-needed addition to the issuer’s compliance toolkit. Once the predictive value of transaction scoring is brought to bear, issuers will likely find it easier to comply with the operational and credit risk requirements of Basel II. figure 2: Bankcard write-offs are declining, but not to pre-recession levels Bankcard Write-Off Rates 12/06 8/06 4/07 12/07 8/07 4/08 12/08 8/08 4/09 12/09 8/09 4/10 4/11 12/10 8/10 14.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 12.00% 3-Month Average Write-Offs 3-Month Average Write-Off Dollar Volume Source: Equifax, April 2011. Reducing loss is only one side of the risk management equation. Managing the changing outlook with regard to revenue and income is the other. That’s what makes the environment currently confronting U.S. issuers so unfamiliar and, in many ways, so threatening. U.S. consumers have become more cautious, more committed to savings, and more determined to pay down credit card debt. Issuers’ risk management approach, developed during a time of unprecedented growth, must change to reflect this new reality. Transaction scoring represents a much-needed addition to the issuer’s compliance toolkit. Once the predictive value of transaction scoring is brought to bear, issuers will likely find it easier to comply with the operational and credit risk requirements of Basel II. Transaction scoring also has value in enabling issuers to see the flip side of risk, which is, of course, opportunity. This flip side has two dimensions. First is the ability to isolate those accounts that might seem risky but, in fact, represent healthy use of the card and carry the potential for future revenue—i.e., false positives. For these good accounts, transaction scoring can provide greater visibility into positive or neutral use of the card that issuers can leverage in up- sell, cross-sell, promotions, and product fine-tuning. The second dimension has to do with accounts that represent an actual— or potential—risk for the issuing institution. For these accounts, the risk management process can become the basis for constructive conversations with account holders in addition to more nuanced credit treatment. Both would be aimed at inducing more judicious and, eventually, more profitable use of the card—ideally, before an adverse action code is generated.
• 4.
  4 ADVANCING INSIGHTSADVANCING COMMERCE. U.S. Insights HOW TRANSACTION SCORING WORKS To put transaction scoring into practice, specialized and proprietary techniques must be used to leverage the data and integrate it with the issuer’s existing decisioning mechanism. That said, transaction scoring: • Is built on a foundation of industry best practices, including historical scoring • Provides significant and quantifiable lift in identifying delinquent accounts earlier and reducing the number of false positives • Can assist institutions in more accurately targeting new exposures, given Credit CARD Act limitations; credit card transaction data has proven to be highly predictive for up-selling existing cardholders to premium payment products and/or cross-selling other products such as home equity loans and mortgages • Provides a benefit to both issuers and consumers by allowing issuers to more finely segment their portfolios and more accurately design interventions for each kind of account, risky or not The key benefit that transaction scoring provides is visibility into account activity. For example, by using transaction scoring in tandem with aggregate consumer transaction behavior, issuers can develop segmentation strategies based on real industry movement in terms of consumer merchant preference. They also can use aggregate consumer behavior data to map individual patterns against industry patterns, regional patterns, and even local patterns. This could enable issuers to more quickly identify early warning signs of industry sectors that may be experiencing weakness. These signs may become visible long before issuers see problems surfacing in their small business or commercial borrower financial statements. Transaction scoring is not an alternative to models based on payment history. Rather, it is a complement to traditional risk models and can provide a substantial and verifiable lift to traditional portfolio management. Several examples are outlined in Figure 3. The key benefit that transaction scoring provides is visibility into account activity. For example, by using transaction scoring in tandem with aggregate consumer transaction behavior, issuers can develop segmentation strategies based on real industry movement in terms of consumer merchant preference.
• 5.
  5TRANSACTION SCORING: WHERERISK MEETS OPPORTUNITY figure 3: Transaction-Based Applications Enable Issuers to Toughen Risk Detection and Maximize Revenue Segment Decision Areas Actions New Accounts Early Month on Book (EMOB) • Product selection (e.g., affluent, cash, etc.) • Decision criteria • Credit limit assignment • Pricing assignment • Segment new accounts more finely (e.g., distinguish potential revolvers/ transactors from customers who would be well-suited to variations on a spend versus revolve product) • Develop pricing and limit-assignment strategies based on historical spending and payment behavior, (e.g., fees vs. APR for transactors and infrequent spenders) Established Accounts (portfolio management) • Credit-limit strategy • Segmentation • Cross-sell • Collections strategy • Adjust over-limit pads based on changes in spending patterns (particularly helpful for No Preset Spending Limit, charge, and commercial cards) • Detect rule and policy violations by commercial account holders (e.g., spending in restricted Merchant Category Codes) • Institute proactive and reactive limit changes (e.g., customers with frequent purchases and high revolve rates may be targeted for credit limit increases) • Create micro-segments based on spending categories to align with products/features • Implement trigger-based collections- block strategies so that customers who continue to attempt purchases while delinquent will be immediately blocked Source: MasterCard Advisors. Transaction scoring provides an added dimension—a view into the behavioral patterns of individual consumers on a near real-time basis as compared with the lag time built into traditional credit report data. By creating account-level variables, transaction scoring greatly increases the accuracy and timeliness of existing models, as shown in Figure 4. Transaction scoring provides an added dimension—a view into the behavioral patterns of individual consumers on a near real-time basis as compared with the lag time built into traditional credit report data. By creating account- level variables, transaction scoring greatly increases the accuracy and timeliness of existing models.
• 6.
  6 ADVANCING INSIGHTSADVANCING COMMERCE. U.S. Insights FIGURE 4: Transaction Elements Are Combined to Create Account-Level Variables that Capture Purchase Behavior Over Time Identify appropriate combinations of transaction characteristics. Capture all transaction dimensions at industry and merchant levels. Apply MasterCard Advisors’ proprietary Variable Creation Process. TRANSACTION- BASED RISK SCORES TRANSACTION- LEVEL DATA • Date and Time • Unique ID • Location • Merchant Industry • Channel • Transaction Type • Transaction Flags • Transaction Amount ACCOUNT-LEVEL AGGREGATE VARIABLES • Recency • Frequency • Monetary • Velocity • Acceleration • Smoothed Time Series • Target Weighted Roll-ups • Customer Activities Apply customized models to create transaction-based risk scores in real time. TEST PREDICTABILITY GENERATE VARIABLES DYNAMICALLY AGGREGATE ATTRIBUTES CLEANSE DATA Source: MasterCard Advisors. Transaction scoring completes the risk-management equation by providing an opportunity to increase revenue while decreasing exposure. When the economy was growing, simply reducing risk was often enough. But in an environment characterized by contraction and caution on the part of both issuers and their customers, more finely tuned risk management is required. The advantages and quantifiable benefits of transaction scoring, both from cost reduction and revenue enhancement points of view, are outlined in Figure 5. Transaction scoring completes the risk-management equation by providing an opportunity to increase revenue while decreasing exposure. When the economy was growing, simply reducing risk was often enough. But in an environment characterized by contraction and caution on the part of both issuers and their customers, more finely tuned risk management is required.
• 7.
  7TRANSACTION SCORING: WHERERISK MEETS OPPORTUNITY figure 5: Transaction Scoring Can Increase Revenue and Reduce Losses Illustrative Applications Reduce Cost/Losses Increase Revenue Behavioral Scoring • More accurately predict risk (identify more “bads”) • Identify risk earlier, affording more time to take loss-mitigation actions • Increase marketable universe/ weed out false positives Collections and Recoveries Modeling • Better predict where accelerated collections strategies are optimal • Optimize contact rate through better understanding of behaviors Payment Program Models • Focus costly outbound programs on likely responders • Increase marketable universe/ weed out false positives (i.e., high- utilization/low-risk accounts) Fraud Modeling • Optimize real-time approvals • Optimize transaction scoring for fraud prevention • Increase authorization approvals vs. false positives Best Customer Acquisition Models • Reduce marketing expense to recruit new cardholders • Increase response rate and/ or lifetime profitability Source: MasterCard Advisors. Quantifying the Benefits of Transaction Scoring Leveraging cardholder information from large U.S. issuers, account transaction data from individual consumers can identify behavior patterns and detect changes in these patterns over time. Building on the results of the data, the algorithms become complementary to the issuer’s traditional credit decisioning practices and portfolio management techniques, significantly enhancing lift as measured by a variety of metrics. MasterCard Advisors’ Financial Stress Propensity Model provides a powerful example. This model is able to identify specific patterns of behavior in accounts that have never been delinquent, but are likely to progress to delinquency within 12 months. In a recent application, the model’s transaction-based algorithms were used in conjunction with existing models to deliver lifts of 10 to 15 percent in Kolmogorov-Smirnov (KS) tests over behavior scores not employing the transaction-based algorithm as an overlay.8 Broadly speaking, the segment analyzed comprised accounts that not only were never delinquent, but were high active transactors with mid FICO scores. The results are shown in Figure 6. Leveraging cardholder information from large U.S. issuers, account transaction data from individual consumers can identify behavior patterns and detect changes in these patterns over time. Building on the results of the data, the algorithms become complementary to the issuer’s traditional credit decisioning practices and portfolio management techniques, significantly enhancing lift as measured by a variety of metrics.
• 8.
  8 ADVANCING INSIGHTSADVANCING COMMERCE. U.S. Insights figure 6: Financial Stress Model Enables Issuer to Significantly Reduce Delinquent Balances in a key segment Applying the model to High active transactors, mid fico range Percent more “bads” identified 3.32% Average line increase $800 Average utilization of incremental line granted 69.3% Total delinquent balances avoided $3-7MM Lift over internal behavioral score 12% Source: Proprietary MasterCard Advisors analysis with major U.S.-based issuer. Advisors’ transaction scoring capabilities have achieved similar results in early month on book (EMOB) applications. A recent project focused on an issuer’s accounts that were six months or newer and at risk of charge-off in 12 months. By using transaction-based algorithms in combination with existing models, the issuer realized an increase in the range of 13 to 17 percent in KS over the historical score alone. By providing a much more robust model, as measured on a KS score, transaction scoring allows a more consumer-centric treatment of adverse actions. Leveraging the positive and neutral behaviors isolated by transaction scoring, whether or not they were potential false positives, issuers can more accurately segment their portfolios based on what consumers are actually doing at the point of sale. BUILDING ON BEST PRACTICES Transaction scoring has been used for years in the U.S. credit card business in a variety of applications, as reported in the Federal Reserve’s 2010 study of 100 card-issuing institutions. While transaction data has been used since the mid-1990s in fraud risk applications, bankruptcy scoring is probably the most widespread credit risk application of transaction scoring at present. Specific cardholder actions (e.g., cash advances at casinos) can trigger a bankruptcy overlay of the historical scoring to which the issuer regularly subjects the account. But an overlay is based on discrete events rather than identifiable patterns and thus is not a transactional score as defined in this paper. A robust variable-based transaction scoring system, which looks at a series of events and the patterns that emerge, can more finely segment risk into immediate or prospective. By enabling a more nuanced decision tree to guide actions (rather than a unitary “red light,” as exemplified by the cash advance), transaction scoring gives the issuer greater flexibility in responding to the series of events. Only some of these actions may be linked to an adverse action code. This increases the likelihood that the action, whatever form it takes, can preserve on a timely basis the viability and future profitability of many more accounts. By providing a much more robust model, as measured on a KS score, transaction scoring allows a more consumer-centric treatment of adverse actions. Leveraging the positive and neutral behaviors isolated by transaction scoring, whether or not they were potential false positives, issuers can more accurately segment their portfolios based on what consumers are actually doing at the point of sale.
• 9.
  9TRANSACTION SCORING: WHERERISK MEETS OPPORTUNITY Having extended credit to the consumer, an issuer could be just as interested in guiding that consumer into more judicious paths as in curtailing the cardholder’s access to credit. By allowing the creation of more narrowly defined segments of risk, as well as of opportunity, transaction scoring fosters a new, positive model of bank/consumer relationships, and allows issuers to look at risk management and marketing as two aspects of a unified account management process. Benefiting CONSUMERS AS WELL AS ISSUERS Transaction scoring enables banks to screen changes in an individual customer’s behavior patterns. This information gives the bank the means to help the customer by demonstrating that he or she, perhaps unknowingly, is going down a path beset with hazards. Transaction scoring helps put the element of time on the side of both the consumer and the issuer. With account scoring methods based exclusively on historical data, the destructive pattern of behavior may be detected when it is simply too late to intervene, resulting in a burden of debt that is likely negative for the institution and the cardholder. From the consumer’s point of view, this time lag often causes huge problems. If the consumer has begun to accumulate debt to the extent that his or her household’s financial position and future—short- or long-term—is affected, it could take months or even years before the consumer can pay his or her way out of trouble. Transaction scoring makes it possible for the bank to intervene before the consumer is too far down the road to delinquency, charge-off, bankruptcy, or balance levels that preclude further card use. Transaction scoring also allows the issuer to continue to afford the consumer access to liquidity at the point of sale over the long term. In an environment in which some consumers are being forced, through a variety of factors, out of the banking system altogether and into the arms of payday lenders, rent-to- own plans, and others, access to liquidity enables banks to provide a much- needed social benefit that was not possible before. The U.S. economy’s larger problems, as well as those of the banking business, result from a lack of liquidity. By definition, a simple rescission of credit will do nothing to solve this problem and may prolong its effects. But issuers, working together with consumers, can create a healthier environment in which the benefits of responsible consumer spending combine with a reasoned extension of credit. Proper management of the bank/consumer relationship using transaction scoring can encourage a more financially educated consumer, whose access to credit money at the point of sale would benefit the consumer and his or her family, as well as the larger economy—including merchants— and the banking system as a whole. ADVERSE ACTION: the Semantic issue The concept of adverse action, or rather the words themselves, deserve some discussion. “Adverse action” is a term of art. But taken as part of a larger toolset of customer engagement strategies, issuers can turn adverse action into a positive event for consumers, as well as for the bank. Obviously, no consumer wants to entertain the prospect of having his or her card declined at the point of sale. But just as in the case of a compromised card, the decline is, in fact, in the cardholder’s best interests, so adverse action, or contacting the consumer before adverse action is necessary, can initiate dialogue on better and sustainable use of the card. The new ability to provide mobile alerts to customers at the point of sale is one example of how this dialogue could begin. Obviously, in certain extreme cases, the issuer may not have an alternative to immediate drastic action—declining the card or capping at balance. But if the issuer keeps the lines of communication open with the cardholder, the prospect of “adverse action” may be an opportunity for consumer education, credit repair, or even cross- or up-sell. Solutions could include different products, additional products (debit, prepaid, other lending vehicles), or help in financial management and spending control with scenario planning, invitations to formal or informal credit counseling, or credit repair strategies.
• 10.
  10 ADVANCING INSIGHTSADVANCING COMMERCE. U.S. Insights TRANSACTION SCORING, THE NEW BUSINESS MODEL The U.S. consumer is not the only entity that has changed since 2008. The transformation in banks’ business models has also been radical. One of the key tools issuers used to grow their business from 1992 to 2008 was the securitization of credit card assets. According to the Fed, pools of securitized assets declined from $661 billion to $131 billion between 2006 and 2010, a compound annual decline rate of 50 percent.9 Changes in rules from the Financial Accounting Standards Board (FASB) are part of the reason; risk aversion on the part of investors is another. But whatever the cause, U.S. credit card issuers are again being forced, after more than 20 years, to lend from their balance sheets. By providing a more nuanced and finely grained risk management framework, transaction scoring can facilitate a greater level of compliance with Basel II and Basel III in terms of operational and credit-risk management and capital requirements. In for a Dime, in for a Dollar Banks contemplating the adoption of transaction scoring should understand that such a decision has large-scale implications for their operations going forward. The adoption of transaction scoring is, in fact, the tip of the iceberg, as Figure 7 shows. FIGURE 7: transaction scoring mandates an enhanced operational Structure Transaction Scoring Customer Relationship and Channel Management Database Management and Information Provisioning Core Account Processing Source: MasterCard Advisors. Banks contemplating the adoption of transaction-based scoring should understand that such a decision has large-scale implications for their operations going forward.
• 11.
  11TRANSACTION SCORING: WHERERISK MEETS OPPORTUNITY Transaction scoring is not a quick fix. Adopting transaction scoring in a way that realizes the technique’s potential may require from-the-ground-up retooling of the issuer’s operations, not simply a refurbishing of the risk management systems. Affected areas may include: • Core account processing • Database management • Decisioning • Customer Relationship Management (CRM) • Channel management (mail, in- and out-bound telephone, email, mobile) • Collections and recovery The issuer must create or retool its existing data management and customer- touchpoint systems to ensure that the results of transaction scoring are integrated into the bank’s larger strategy, product design and implementation, marketing, and electronic payments platform. This becomes especially important if the bank has multiple relationships with the consumer, including deposit accounts. While by no means transparent, adopting transaction scoring does not have to be disruptive, or even onerous. It builds, or ought to build, on efforts that progressive institutions and their processors and partners have been working on for years; these likely include database management in the interest of superior customer service, Internet and mobile functionality, and modular core account processing. CONCLUSION Leading institutions are already starting to leverage the power of transaction data to their advantage. Banks that fail to move in this direction will find themselves employing out-of-date risk management tools that are incapable of reflecting the near real-time requirements of decisioning in the new environment. Widespread adoption of transaction scoring will result not only in a more competitive playing field among financial institutions, but also a more fruitful lending environment for consumers. endnotes 1 Proprietary MasterCard Advisors analysis with major U.S.-based issuer. 2 Source Media, “Card Industry Directory,” 20th Edition, 2008. 3 Board of Governors of The Federal Reserve System, “Report to the Congress on the Profitability of Credit Card Operations of Depository Institutions,” June 2010. 4 Equifax, April 2011. 5 Nilson Reports #965 and #942, U.S. Census Bureau. 6 Ibid. 7 Equifax, April 2011. 8 Proprietary MasterCard Advisors analysis with major U.S.-based issuer. 9 Federal Reserve Statistics Release, “Consumer Credit G.19,” June 2011. While by no means transparent, adopting transaction scoring does not have to be disruptive, or even onerous. It builds, or ought to build, on efforts that progressive institutions and their processors and partners have been working on for years; these likely include database management in the interest of superior customer service, Internet and mobile functionality, and modular core account processing.
• 12.
  ADVANCING INSIGHTS ADVANCINGCOMMERCE. ©2011 MasterCard. All rights reserved. Proprietary and Confidential. Insights and recommendations are based on proprietary and third-party research, as well as MasterCard’s analysis and opinions, and are presented for your information only. For additional insights, please visit www.mastercardadvisors.com and insights.mastercard.com. about the authors Westley Koenen Westley Koenen is Senior Vice President and Group Head of Global Risk Solutions within MasterCard Advisors. As head of Advisors’ global credit risk business, Mr. Koenen and his team focus on helping consumer and commercial lenders to leverage MasterCard’s deep knowledge and data assets in all aspects of the credit risk lifecycle—from acquisition marketing to consumer insights. Prior to joining MasterCard Advisors, Mr. Koenen was General Manager and Head of Sales for Experian Consumer Direct, the single largest business unit within Experian PLC. Based in San Ramon, CA, Mr. Koenen can be reached at [email protected]. Theodore Iacobuzio Theodore Iacobuzio is vice president in charge of Global Insights, MasterCard’s interdisciplinary thought leadership organization. He and his team use research and analysis to better understand consumer behavior and market dynamics—and how those insights can strengthen the business performance of MasterCard customers around the world. Under his direction, MasterCard has published groundbreaking work on payments profitability, the myth of debit “cannibalization,” global debit point-of-sale migration, remittances in Asia/Pacific and the Middle East, and affluent segmentation in Brazil. Prior to joining MasterCard in 2009, Mr. Iacobuzio led the Payments Practice at TowerGroup. Based in Purchase, N.Y., he can be reached at [email protected]. Contributors JP Gerard Vice President, Analytics Delivery MasterCard Advisors Michael Cimatu Vice President, Operations and Platforms MasterCard Advisors Jeff Bank Global Head of Product, Credit Risk and Fraud MasterCard Advisors Melton Knight Vice President, Credit Risk and Fraud Knowledge Center MasterCard Advisors U.S. Insights