Prediction of default probability by using statistical models for rare events

Prediction models in credit scoring usually involve the use of data sets with highly imbalanced distributions of the event of interest (default). Logistic regression, which is widely used to estimate the probability of default, PD, often suffers from the problem of separation when the event of interest is rare and consequently poor predictive performance of the minority class in small samples. A common solution is to discard majority class examples, to duplicate minority class examples or to use a combination of both to balance the data. These methods may overfit data. It is unclear how penalized regression models such as Firth's estimator, which reduces bias and mean‐square error relative to classical logistic regression, performs in modelling PD. We review some methods for class imbalanced data and compare them in a simulation study using the Taiwan credit card data. We emphasize the effect of events per variable for developing an accurate model—an often neglected concept in PD‐modelling. The data balancing techniques that are considered are the random oversampling examples and synthetic minority oversampling technique methods. The results indicate that the synthetic minority oversampling technique improved predictive accuracy of PD regardless of sample size. Among the penalized regression models that are analysed, the log‐F prior and ridge regression methods are preferred.