Credit Risk Management Using Machine Learning

Zoran Ereiz
Faculty of Information Technology
Mostar, Bosnia-Herzegovina
zoran.ereiz@edu.fit.ba

Abstract—Credit risk management is essential to financial With a good model financial institutions could make
institutions as it directly affects business results. Although AI predictions how likely is a client to repay the loan before the
and machine learning are not new, microcredit organizations maturity date and then take actions prior to this happening
are shy in accepting these methods in their credit risk (Fig. 1).
assessment process and still use standards credit scoring based
on a linear calculation of a small number of indicators. This
scoring model gives mixed and unreliable results. Machine
learning, on the other hand, offers a much broader view of a
client and can be used to manage not only credit risk but other
business risks too. As this paper demonstrates, prediction ratio
is very high but depends on the quality of the data.

Keywords—AI, machine learning, risk management, credit

risk, dataset, prediction

I. INTRODUCTION
Fig. 1. Credit risk management system using machine learning
Credit risk is one of the most important risks to be
managed by a financial institution. Without loan repayment To mitigate the subjective part of the decision making
there is no profit, hence the problem of credit risk management process, different scoring models are introduced to evaluate
is relevant to all financial institutions involved in lending to certain parameters that could affect the loan repayment. In
individuals and legal entities. This is even more true with general, these parameters include, but are not limited to:
microcredit organisations who have only one product - loans.
Banks have a diverse portfolio so the risk is somewhat  income
mitigated but credit risk is still the most important to manage.
 loan amount
Credit risk is economic loss that emanates from the failure
 loan term
of a counterparty to fulfill its contractual obligations (e.g.,
timely payment of interest or principal), or from the increased  client's age
risk of default during the term of the transaction. Traditionally,
financial firms have employed classical linear, logit, and  client's gender
probit regressions to model credit risk[1].  number of household members
A standard credit score is largely a linear calculation of a  place of living (urban/rural)
small number (about 50) positive or negative numerical
characteristics about a person and thus misses out on a huge  industry of business (if business loan)
amount of additional personal information that can help to
either reduce negative risk or accept positive risk[2].  loan product

The management of credit risk of credit portfolios is  loan cycle

therefore one the most important tasks for the financial  previous loan days in arrears
liquidity and stability of banking sector in connection with
increased sensitivity of banks to the credit risks and changes  current credit classification
in the development of prices of financial instruments[3].
Credit risk management is a matter of predicting the  client's credit history
possibility of a default loan. Different financial institutions  credit history for address (municipality)
manage credit risks in different ways but in general the goal is
always the same.  various financial indicators

II. CREDIT SCORING WITH MACHINE LEARNING
The use of AI and machine learning to create a credit risk
management model is not new but in the recent years it is
growing rapidly. It is particularly the increased complexity of
assessing credit risk that has increased the attention to
machine learning. Using machine learning algorithms a new
model could be created using existing anonymised historical
data that would be used to train the model to make better
predictions not only for credit risks but also for other risks like
the possiblity of early repayment resulting in income losses
from interest, the possibile danger of money laundering etc.
Various combinations of these parameters are scored to
identify a potential credit risk. However, these parameters are
mostly general (e.g. credit history for municipality, place of
living...) and do not give an accurate prediction. In
Microcredit Organization EKI (MCO EKI) as of beginning of
July 2019 there were 40812 active loans and out of this
number 10185 loans received a bad credit scoring, out of
which 1507 are late and 183 are in default. On the other hand,
out of 30627 loans that received a good/passing score 2837
are late and 300 are in default. Obviously the scoring system
currently in use is not giving good results.

©2019 IEEE
 III. PREPARING THE DATASET
During the loan application process various data about the
client, client's household and business is collected. Some of
the data is relevant to credit risk prediction and some is not. A
dataset with the most relevant information (based on previous
experience in the financial institution) is created from a
database of 150091 loans. Out of this number 40812 are still
active while the remainder are closed i.e. repaid in one way or
the other. A sample of 3612 loans will be used for the purpose
of this paper while the full dataset will be used in the
implementation of the model. The sample dataset contains
loans covering a period from June 2014 to July 2015 (about a
year of disbursed loans).
In cooperation with employees from the Risk and
Operations department a table was created containing records
deemed important to the credit risk management. The table
consists of the following 29 indicators characterizing the
borrower and loan:
 loLoanID
 AgreementNo
 ContactCode
 Amount
 Term
 Default
Some of these indicators (e.g. EarlyRepaid, WOF,
LateWithPayment...) represent information that is available
during repayment or after the loan is closed and as such
directly indicates the prediction outcome the model is
supposed to make so after further analysis they were deemed
irrelevant for the model and removed from the dataset. The
dependent variable in our dataset is a binary indicator with the
value of 1 flagging a default loan.
With the General Data Protection Regulation (GDPR)
additional impediments are created since data can no longer
be saved and used without consent if there isn't a contractual
relationship between the client and the financial institution.
This creates problems regarding saving and using data in the
model.
At MCO EKI a loan is flagged as delinquent if the client
fails to pay a monthly installment in the month it is due. Days
in arrears (number of days from when the installment was due
to the actual payment) are also tracked but as long as the
payment is made within the month the client/loan is not
delinquent. If the loan is 180 days late it is written off i.e.
deemed uncollectable through regular procedure and it has to
be collected through court. Usually, a loan that is written off
has also had installments transferred to another month before
payment was made.

 GracePeriod The first stage is cleaning the dataset. The dataset doesn't
contain any N/A or null values which is good. The next step
 Cycle is to remove columns that are irrelevant to the model being
built. This is dangerous because it could lead to an overfitted
 Business/Nonbusiness dataset resulting in low performance outcome. The following
 Product categories (table columns) were removed because they are
unavailable in the application approval process:
 Branch
 WOF
 LO
 NoMonthlyTransfers
 WOF
 FirstInstallmentTransferred
 NoMonthlyTransfers
 LateWithPayment
 FirstInstallmentTransferred
 FirstInstallmentLate
 LateWithPayment
 EarlyRepaid
 FirstInstallmentLate
 NoMonthsRepaid
 EarlyRepaid
The dataset is divided in 2 groups: train and test group
 NoMonthsRepaid where the training table contains 75% of the dataset. The test
table will be used to confirm the model after it is trained.
 CRK_Category
To generate the best suited model we used BigML's
 HH_Members OptiML, an automatic optimization option that allows users to
 HH_Members_No_Income find the best supervised learning model for the submitted data
(Fig. 2).
 RuralUrban
 Municipality
 EmploymentStatus
 Gender
 AgeAtDisbursement
 DocumentedIncome
 IncomePerHH_Member

Fig. 2. OptiML Model Optimization
 It can be used for both classification or regression
problems.
 It works by automatically creating and evaluating
multiple models with multiple configurations (decision
trees, ensembles, logistic regressions, and deepnets) by
using Bayesian parameter optimization.
 When the process finishes, it provides a list of the best
models for comparison and selection of the one that
best suits the use case.
The OptiML algorithm is split into two phases. The first,
the “parameter search” phase, uses a single holdout set to
iteratively find promising sets of parameters. The second, the
“validation” phase is used to iteratively perform Monte Carlo
cross-validation on those parameters that are somewhat close
to the best (Fig. 3).
Fig. 3. Model creatation and evaluation
For this second phase, the algorithm iteratively does new
train/test splits for the top half of algorithms remaining. Thus,
the best models will typically have more than one evaluation
associated with them.
After completion there is a report showing elapsed time,
evaluated models, number of candidate models and the
number of created models (Fig. 4).
Fig. 4. Model creatation report
The best model based on the supplied data was a bootstrap
decision forest (Fig.5).
Fig. 5. Model evaluation first attempt
After running the model on the test data it returned 68
incorrect predictions out of a dataset of 903 or 7.53%.
However, the most important field in this model was LO
(Loan Officer) followed by client’s municipality (Fig. 6).
Fig. 6. Top 5 field importance
This did not make much sense so a new model was created
on a new dataset excluding some other fields:
 ContactCode
 Branch
 LO
 Municipality
 DocumentedIncome
Unfortunately, this caused every model to give poor
performance results (Fig. 7).
Fig. 7. Model evaluation second attempt
IV. CONCLUSION
Financial institutions are increasingly turning to AI and
machine learning not only for credit risk management, but also
to manage other risks like financial fraud, money-laundering,
the risk of not being in compliance with regulations (potential
risk of being fined by the regulator), client behaviour that
could lead to potential income loss to the financial institution
etc. All these risks can be managed using various AI and
machine learning techniques.
 There are some significant practical issues that need to be
addressed before AI and machine learning techniques for risk
management can claim its full potential. The most important
of these is the availability of suitable data. In practice the
process of model building is always hampered by the
availability and quality of data [4]. The collection process is
never perfect or completely accurate and the data often contain
inconsistencies or missing values. Another issue is the
availablity of skilled staff to implement these new techniques.
There is also the issue of how accurate the model is. Due to
neverending changes in the lending market the model should
be seen as a live matter and constantly monitored and adjusted.
However, a machine learning model created this way
would enable the financial institution to make better and more
objective decisions regarding loan approval, to prevent
internal and/or external fraud, suppress money-laundering
activities and predict client behavior to prevent clients from
leaving, attracting them with new custom-designed loan
products etc.
For future work a full set of data (at the moment 150091
loans) should be used to confirm the findings of this research
and the model implemented at MCO EKI.
ACKNOWLEDGMENT
The author would like to thank MCO EKI for making the
data available for this research.
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