Roughness Penalty for liquid Scorecards

Abstract: A liquid scorecard has liquid characteristics, for which the characteristic score is a smooth function of the characteristic over a liquid range. The smooth function is based on B-splines, typically cubic. In contrast, the characteristic scores for traditional scorecards are step functions of the characteristics. Previously, there were two ways to control the smoothness of the liquid characteristic score: (1) coarse classing where the fewer the number of classes, the smoother the curve; (2) the penalty parameter, which penalizes the norm of the score coefficient vector. However, in classical cubic spline fitting theory, a direct measure of curve roughness is used as a penalty term in the fitting objective function. In this paper, I work out the details of this concept for our characteristic scores, which are linear functions of a cubic B-spline basis. The roughness penalty is the integral of the second derivative squared. As you vary the characteristic smoothness parameter from zero to infinity, the characteristic score goes from being rough to being very smooth. As one moves from rough to smooth, the palatable characteristic score jumps off the page. This is illustrated by a case study. This case study also shows that smoothness parameters, which maximize validation divergence, do not always yield the most palatable model.