Modelling the profitability of credit cards by Markov decision processes

0377-2217/$ see front matter 2011 Elsevier B.V. A doi:10.1016/j.ejor.2011.01.023 ⇑ Corresponding author. Tel.: +44 0 7796035843. E-mail addresses: [email protected] (M.M.C. So) Thomas). This paper derives a Markov decision process model for the profitability of credit cards, which allows lenders to find an optimal dynamic credit limit policy. The states of the system are based on the borrower’s behavioural score and the decisions are what credit limit to give the borrower each period. In determining which Markov chain best describes the borrower’s performance, second order as well as first order Markov chains are considered and estimation procedures developed that deal with the low default levels that may exist in the data. A case study is given in which the optimal credit limit is derived and the results compared with the actual outcomes. 2011 Elsevier B.V. All rights reserved.