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Profit-based credit models with lender’s attitude towards risk and loss

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  • Baidoo, Edwin
  • Natarajan, Ramachandran

Abstract

Profit scoring represents a shift from default risk modeling. Here, lenders align their lending strategies to reflect their profitability objective. This paper proposes models that address the lender’s profit maximization objective. We develop varying cutoff functions that inform lending decisions while considering a lender’s attitude towards risk and loss. We derive two propositions about the properties of the variable cutoff functions for risk-averse and loss-averse lenders. Using a proprietary consumer loan data set, we show the effect of cutoff functions in lending decisions and find that both risk-averse and loss-averse lenders are profitable if they use parameter estimators that support their profitability objective.

Suggested Citation

  • Baidoo, Edwin & Natarajan, Ramachandran, 2021. "Profit-based credit models with lender’s attitude towards risk and loss," Journal of Behavioral and Experimental Finance, Elsevier, vol. 32(C).
    • Handle: RePEc:eee:beexfi:v:32:y:2021:i:c:s2214635021001222
    DOI: 10.1016/j.jbef.2021.100578
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit scoring; Profit scoring; Risk-aversion; Loss-aversion; Prospect theory; Cumulative prospect theory;
    All these keywords.

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • D12 - Microeconomics - - Household Behavior - - - Consumer Economics: Empirical Analysis
    • G51 - Financial Economics - - Household Finance - - - Household Savings, Borrowing, Debt, and Wealth

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