# Parametric versus nonparametric methods in risk scoring: an application to microcredit

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## Abstract

The importance of credit access to improve economic opportunities in developing markets is well established in the literature. However, there exists a strong need to mitigate adverse selection problems in microlending. A risk scoring model that more accurately predicts the likelihood of repayment of potential borrowers can help address this market imperfection and to benefit both lenders and borrowers. This paper compares the performance of nonparametric versus semiparametric and traditional parametric risk scoring models based on default probabilities. We show the advantages of relying on less structured, data-driven methods for risk scoring using both simulated data and data from credit loans granted to small and microenterprises in rural Peru. The estimation results indicate that nonparametric methods lead to a better evaluation of credit worthiness and can help prevent including potential “bad” borrowers and excluding “good” borrowers from sensitive microcredit markets.

## Keywords

Risk scoring Microcredit Default models Nonparametric methods## JEL Classification

C14 O16 G17## Notes

### Acknowledgments

We would like to thank Qi Li, Carlos Martins-Filho, Robert Kunst, and two anonymous referees for their valuable comments. We also thank Christopher Marciniak for his valuable research assistance.

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