Comparison of Machine Learning Techniques when Estimating Probability of Impairment : Estimating Probability of Impairment through Identification of Defaulting Customers one year Ahead of Time

University essay from Umeå universitet/Institutionen för matematik och matematisk statistik; Umeå universitet/Institutionen för matematik och matematisk statistik

Abstract: Probability of Impairment, or Probability of Default, is the ratio of how many customers within a segment are expected to not fulfil their debt obligations and instead go into Default. This is a key metric within banking to estimate the level of credit risk, where the current standard is to estimate Probability of Impairment using Linear Regression. In this paper we show how this metric instead can be estimated through a classification approach with machine learning. By using models trained to find which specific customers will go into Default within the upcoming year, based on Neural Networks and Gradient Boosting, the Probability of Impairment is shown to be more accurately estimated than when using Linear Regression. Additionally, these models provide numerous real-life implementations internally within the banking sector. The new features of importance we found can be used to strengthen the models currently in use, and the ability to identify customers about to go into Default let banks take necessary actions ahead of time to cover otherwise unexpected risks.

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