FICO® Scores are designed to rank-order the expected future payment performance of consumers’ credit obligations based on their credit bureau characteristics, irrespective of the economic environment. Lenders may calibrate FICO Scores based on their own loan portfolios’ recent performance to predict the odds of satisfactory payment performance.
However, disruptions to the economic environment put stress on consumers that can change these repayment odds in a way that differs from a lender’s calibrated estimates, leading to discrepancies between predicted and actual future default odds, and ultimately to suboptimal credit decisions. Such disruptions reveal “latent risks” within portfolios that only manifest during periods of economic stress. A formidable challenge for credit risk management is that disruptions can be extremely difficult if not impossible to anticipate as the COVID-19 pandemic again demonstrates. This leads to the basic question: “How can we measure, and then manage, latent risks?”
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