Machine Learning applications in Credit Risk

Presented By: Location:

Sri Krishnamurthy, CFA, CAP ARPM Open Source Conference
sri@quantuniversity.com 8/13/2017
www.analyticscertificate.com
2017 Copyright QuantUniversity LLC.
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Slides will be available at:

www.analyticscertificatecom/MachineLearning
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• Founder of QuantUniversity LLC. and

www.analyticscertificate.com
• Advisory and Consultancy for Financial Analytics
• Prior Experience at MathWorks, Citigroup and
Endeca and 25+ financial services and energy
customers.
• Regular Columnist for the Wilmott Magazine
• Author of forthcoming book
“Financial Modeling: A case study approach”
published by Wiley
Sri Krishnamurthy • Charted Financial Analyst and Certified Analytics
Founder and CEO Professional
• Teaches Analytics in the Babson College MBA
program and at Northeastern University, Boston
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Quantitative Analytics and Big Data Analytics Onboarding

• Data Science, Quant Finance and
Machine Learning Advisory
• Trained more than 1000 students in
Quantitative methods, Data Science
and Big Data Technologies using
MATLAB, Python and R
• Launching
▫ Analytics Certificate Program
 Spring 2018
▫ Fintech Certification program
 Fall 2017
• Building
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Credit risk in consumer credit
Credit-scoring models and techniques assess the risk in lending to
customers.

Typical decisions:
• Grant credit/not to new applicants
• Increasing/Decreasing spending limits
• Increasing/Decreasing lending rates
• What new products can be given to existing applicants ?
Credit assessment in consumer credit
History:
• Gut feel
• Social network
• Communities and influence

Traditional:
• Scoring mechanisms through credit bureaus
• Bank assessments through business rules

Newer approaches (FINTECH):

• Peer-to-Peer lending
• Lending club, Prosper Market place
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Types of algorithms

Prediction
Supervised
Learning
Machine Classification
learning
Unsupervised
Clustering
Learning
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Supervised Learning
Used to derive a relationship between dependent and independent
variables
• Prediction
▫ Regression
▫ Decision Trees (CART)
▫ Neural Networks
• Classification
▫ Logistic Regression
▫ CART, Random Forest, SVM
▫ Neural Networks
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Methodology

Test the model

Split data into
Data pre- Train the model using Testing data
Training and
processing on Training data to evaluate model
Testing sets
performance
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Unsupervised Learning
• No distinction between independent variables and dependent
variables
• No result labels to determine “correct” results
• Goals:
▫ Data Reduction
▫ Clustering
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Types of Clustering
• Partitioning Clustering
▫ Starts with K –number of clusters sought
▫ Observations randomly divided to form cohesive clusters
▫ Example : K-means
• Hierarchical Agglomerative Clustering
▫ Each observation is its own cluster
▫ Combine clusters two at a time to finally have one cluster
▫ Example: Hierarchical clustering using single linkage, Ward’s method
etc.
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K-means
• Tries to separate samples into K groups with a goal of maximizing
between group variance and minimizing within group variance
• Requires K to be specified up front.
• Starts with K initial centroids and optimizes to minimize the criterion
or till the number of specified iterations are reached.
• Suited for larger datasets
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Hierarchical clustering
• Goal is to derive a dendrogram starting from each record being its
own cluster
• Works well for smaller data sets
• Proximity is measured in multiple ways (more later)
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The notion of distance

How do you measure similarity between two entities ?
▫ Apples and Bananas
▫ Coke and Pepsi vs Orange juice
▫ Honda Civic vs Toyota Corolla
▫ New York and Boston
• The notion of distance
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Distance measures
• Euclidean distance

• Cosine distance
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Other distance measures

• Manhattan distance
(Taxi-cab distance)

• Jaccard distance
▫ Used to measure similarity or dissimilarity between binary and non-
binary variables
▫ http://people.revoledu.com/kardi/tutorial/Similarity/Jaccard.html
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Working with mixed-data

• Gower distance is used for calculating distances when we have mixed types
of variables (continuous and categorical)
• Variables can be:
▫ Quantitative (such as rating scale)
▫ Binary (such as present/absent)
▫ Nominal (such as worker/teacher/clerk)
• The metrics used for each data type are described below:
▫ Quantitative: range-normalized Manhattan distance
▫ Ordinal: variable is first ranked, then Manhattan distance is used with a special
adjustment for ties
▫ Nominal: variables of k categories are first converted into k binary columns and
then the Dice coefficient is used
(https://en.wikipedia.org/wiki/S%C3%B8rensen%E2%80%93Dice_coefficient )
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Support in R
• Daisy : Compute all the pairwise dissimilarities (distances) between
observations in the data set
• Pam: Partitioning (clustering) of the data into k clusters “around
medoids”, a more robust version of K-means.
• Agnes: Computes agglomerative nesting (hierarchical clustering) of
the dataset.
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Lending club
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The Data

https://www.lendingclub.com/info/download-data.action
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The Data

https://www.kaggle.com/wendykan/lending-club-loan-data
Variable description
Objective
• Calculate dissimilarity between observations.
• Select algorithm to group observations together
• Choose the best number of clusters
• Visualize clusters on reduced dimensions
Selecting number of clusters
• Partitioning around medoids (PAM) is used in this case.
• PAM is an iterative clustering procedure with the following steps:
▫ Step 1: Choose k random entities to become the medoids.
▫ Step 2: Assign every entity to its closest medoid (using the distance
matrix we have calculated).
▫ Step 3: For each cluster, identify the observation that would yield the
lowest average distance if it were to be re-assigned as the medoid. If
so, make this observation the new medoid.
▫ Step 4: If at least one medoid has changes, return to step 2.
Otherwise, end the algorithm.
Visualization with reduced dimension
• One way to visualize many variables in a lower dimensional space is
with t-distributed stochastic neighborhood embedding (t-SNE)
• This method is a dimension reduction technique that tries to
preserve local structure so as to make clusters visible in a 2D or 3D
visualization.
• https://en.wikipedia.org/wiki/T-
distributed_stochastic_neighbor_embedding
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Alternative Credit scoring in the news

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Fintech being noticed by Regulators

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Regulatory Sandboxes
• The regulatory sandbox allows businesses to test innovative
products, services, business models and delivery mechanisms in the
real market, with real consumers.

• The sandbox is a supervised space, open to both authorized and

unauthorized firms, that provides firms with:
▫ reduced time-to-market at potentially lower cost
▫ appropriate consumer protection safeguards built in to new products and
services
▫ better access to finance

• https://www.fca.org.uk/firms/regulatory-sandbox
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US Regulators catching up
Model Validation

• “Model risk is the potential for adverse consequences from

decisions based on incorrect or misused model outputs and
reports. “ [1]

• “Model validation is the set of processes and activities

intended to verify that models are performing as expected,
in line with their design objectives and business uses. ” [1]

• Ref:
• [1] . Supervisory Letter SR 11-7 on guidance on Model Risk
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Popularity of Open-source software in the enterprise

increasing
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Cloud maturing
• Financial Services customers like Capital One, FINRA, and Pacific Life
are moving critical workloads to AWS
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Challenges in adopting Open-source software in the

enterprise
• Versions and packages
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Challenges in adopting Open-source software in the

enterprise
• Difficulty in replicating and reconciling differences in environments
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Challenges in adopting Open-source software in the

enterprise
• Deploying models built by Data Scientists still a problem

Data Scientists Enterprise IT

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Challenges in adopting Open-source software in the

enterprise
• The try-before-adopt model is difficult with unproven open-source
solutions
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www.QuSandbox.com
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Use cases
Quant/Enterprise use cases
• Create an environment that can support multiple platforms and
programming languages
• Enable remote running of applications
• Ability to try out a Github submission/ someone else’s code
• Facilitate creation of Docker images to create replicable containers
• Create prototyping environments for Data Science/Quant teams
• Enable Data scientists/Quants to deploy their solutions
• Enable running multiple experiments concurrently
• Integrate seamlessly with the cloud to scale up computations
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Use cases
Fintech use cases
• To demonstrate solutions to enterprises
• Create customized enterprise trials for companies that don’t permit
installation of vendor software prior to procurement
• To manage quick updates
• Enable effective integration and hosting of services (REST APIs)
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Use cases
Academic use cases
• Enable creation of course material and exercises that could be
shared
• Enable students and workshop participants to focus on the data
science experiments rather than environment setting
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Creating replicable environments

Creating and manage replicable environments (Code + software + data) in a single portal
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Creating replicable environments

Create replicable environments (Code + software + data) through a easy point & click tool and
publish to Dockerhub or manage internally
Share it with target users
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User portal

• Run multiple experiments in pre-created environments (Code + software + data)

• Deploy your own solutions
• Run any Docker image or Github submission on the cloud
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Run Jupyter notebooks and prototype applications

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Run Rstudio and Shiny applications

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Run any Docker application

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Manage tasks and errors

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User portal

• Dockerize and deploy applications on AWS in just a few steps

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Deploy applications with ease

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QU’s open source project – Project Mozaic

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www.QuSandbox.com
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www.analyticscertificatecom/MachineLearning
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Thank you ARPM and enjoy the boot camp!

Checkout our programs at:
www.analyticscertificate.com/fintech
www.qusandbox.com

Sri Krishnamurthy, CFA, CAP

Founder and CEO
QuantUniversity LLC.
srikrishnamurthy
www.QuantUniversity.com
Information, data and drawings embodied in this presentation are strictly a property of QuantUniversity LLC. and shall not be
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