Machine Learning and Credit Risk (part 2) – Credit Cycle Method

The canonical method to forecasting a credit migration matrix is an econometric model: the one factor approach described in Belkin et al. (1998). This approach suggests that one might consider an approach to condition migration (transition) matrices by creating a systematic component which represents the “credit cycle” that relates the economic condition to the credit quality of a loan portfolio.  The credit cycle can be thought of as the historical pattern of credit rating shared by all borrowers in a sector or economy.Read More »

Machine Learning and Credit Risk (part 1)

Artificial Intelligence (AI) and Data Science continue their progression towards becoming mainstream and ubiquitous. This is a very exciting time for scientists, model developers, programmers, and a lot of other technically inclined professionals. But to be honest it can be confusing and overwhelming at times. We all hear terms like “AI”, “Data Science”, “Big Data”, “Machine Learning”, “Statistical Learning”, “Data Mining”, “Deep Learning”, etc., and it’s often hard to make sense of it all even for those of us who have been writing code to implement statistical models for decades. But it seems these terms are being used among people in every field and every industry. How do remote sensing professionals use data from a satellite to create land cover maps? how do certain streaming services determine what shows or movies to recommend based on your watching habits? How did Cambridge Analytica determine the poor shmucks Donald Trump should focus on? The answers to all these questions lay in machine learning algorithms.  (If interested you can find more information on the differences or definitions of all the terms mentioned above on various discussion threads on social sites like Quora, StackExchange, LinkedIn, and KDNuggets among others.)

This article will be a little more focused on the question: how can we use machine learning in areas where statistics have traditionally been employed in credit risk?

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Using Multidimensional Linear Interpolation to find Economic Capital Rates

In banking, Economic Capital (EC), is an internal measure of capital required to absorb unexpected losses while remaining solvent at a targeted solvency level. It provides a common basis for comparing risk-adjusted profitability and relative economic value of lines of business and asset classes with varying degrees and sources of risk.  EC has various applications that include performance measurement, risk-adjusted pricing, capital allocation, capital adequacy and risk concentration management. EC can be allocated at either a loan, facility or line of business level.

Economic Capital is statistically/quantitatively determined and designed to be sensitive to changes in loan characteristics (risk factors) as a result of both systematic and idiosyncratic factors. Very often EC is calculated through the use of Monte Carlo Simulation – An analytical technique that involves performing a large number of random iterations, called simulations, to generate a statistical distribution of possible outcomes.  In finance, Monte Carlo simulations are used to value and analyze complex instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value.Read More »