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• Comment: A project report, not an encyclopedia article. bonadea contributions talk 15:31, 31 October 2024 (UTC)

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Utilizing machine learning to predict loan default.

EXECUTIVE SUMMARY

This project aimed to develop a robust predictive model for loan default prediction, leveraging machine learning techniques to improve financial decision-making processes. The primary goal is to identify key risk factors associated with loan default and to build a model that could accurately predict default probabilities for new applicants.

Through an extensive evaluation of various machine learning algorithms, including Random Forest, Decision Tree, Logistic Regression, K-Nearest Neighbour, Naive Bayes, Linear Discriminant Analysis, and Gradient Boosting, the Random Forest model emerged as the most effective. After hyperparameter tuning, the Random Forest model achieved a remarkable accuracy of 99%, with macro and weighted average F1-scores also at 99%, indicating excellent model performance. The model's AUC score of 0.99 further validated its predictive power.

Key deliverables from this project include the optimized Random Forest model, which was rigorously tested and validated. Additionally, explainable AI techniques such as feature importance, Partial Dependence Plots (PDPs), Permutation importance and Local Interpretable Mode-Agnostic Explanations (LIME) were employed to provide transparency into how specific features influenced the model's predictions. Additionally, the project involved the development of a comprehensive website that showcases the model's predictions and allows users to interact with the loan default prediction system in a user-friendly manner also Loan default dashboard was developed using Power BI for customers and financial institutions to get insights on the major contributors of loan default.

The practical impact of this project is significant, as it offers a powerful tool for banks and lending institutions to assess the likelihood of loan defaults more accurately. By implementing this predictive model, lenders can mitigate risks, tailor loan products to individual borrowers' profiles, and enhance the overall efficiency of the lending process.

BUSINESS DOMAIN

The project is directed at financial institutions, including banks and lending companies, who seek to enhance their loan approval processes and mitigate the risk of default.

INTRODUCTION

In today’s dynamic financial environment, accurately assessing and mitigating the risk of default on loans is crucial to the sustainability and success of lending institutions. . This project aims to validate a model tailored for the financial sector, focusing specifically on personal unsecured loans, with a clear emphasis on efficiency in terms of minimizing the risk associated with such loans. The project seek to use machine learning models to provide robust risk assessment tools, considering the inherent uncertainty and variability in lending decisions. The goal is to equip financial institutions with practical insights to optimize lending strategies, minimize risk exposure, and improve overall portfolio performance. In doing so, the project will contribute to the advancement of risk management practices, promoting stability and resilience in the face of market dynamics and changes in economic uncertainty.

PROBLEM AND OBJECTIVES

Problem Statement

The problem to be addressed in this study is the challenge of accurately predicting loans in default, a crucial problem in the financial industry. Online personal loans have grown in popularity over the years due to the continuous evolution of technology. Users of such platforms find it easier to borrow money; however, interest rates on delayed repayments and processing fees have increased, increasing the risk of non-payment. With increasing economic volatility and uncertainty, financial institutions face significant challenges in accurately assessing credit risk. Loan default presents a tangible problem for both lenders and borrowers, impacting financial stability, credit availability, and overall economic health

Falling to address the challenges of accurately predicting loan defaults can lead to severe negative consequences that can put a strain on financial institution, which may lead to liquidity issues, reduced profitability, and even bankruptcy in extreme case. For borrowers, defaulting on a loan can result in severe financial distress, including damage to the credit score, loss of assets, and limited access to future credit. Another issue can be economic stability; as we know, widespread loan defaults can destabilize economies, causing ripple effects across various sectors, including reduced consumer spending, decreased investment, and increased unemployment

To improve the predictive model for loan default, the study will delve deeper into secondary data and apply advanced machine learning techniques to improve predictive accuracy. It will also conduct comprehensive analyses to identify and evaluate various risk factors that contribute to loan defaults, including economic indicators and borrower characteristics. Additionally, the study will validate the performance of the model through rigorous testing and comparison with industry standards to ensure reliability.

Business Objectives

• Analyse historical loan data to identify key predictors of loan default within the financial industry, specifically on personal unsecured loans.

• Develop and implement machine learning algorithms, including ensemble methods and feature engineering, to create a model that can predict loan default.

Evaluation of the performance of the developed model through rigorous testing and validation against industry standards, ensuring reliability and applicability within the financial services sector

SCOPE

In-Scope 

• Feature engineering and selection methods to enhance model effectiveness.

• Dashboard to get insight into the dataset and key feature contributors to loan default.

• Implementation of supervised machine learning methods like Decision Trees (DT), Logistic Regression (LR), K-Nearest Neighbour (KNN), Linear Discriminant Analysis (LDA), Gradient Boosting (GB), Random Forest (RF), and Naïve Bayes (NB).

• Website for real time predictions of loan default.

Explainability and Interpretability of the final model using Explainable AI.

Out-of-Scope

• Deep learning techniques will not be considered due to the complexity and resource requirements.

• Integration with external third-party APIs for credit scoring will not be explored.

Ethical and legal considerations beyond basic model fairness will not be addressed in depth.

illustrates the six phases of CRISP-DM

SOLUTION

Overview of Methodology

This project employs the CRISP-DM (Cross-Industry Standard Process for Data Mining) methodology, which is widely recognized and comprehensive, making it particularly suitable for predictive modeling tasks like loan default prediction . The iterative nature of CRISP-DM allows for continuous refinement of the analysis as more insights are gained from the data.

The first phase, Business Understanding, involves clarifying the financial and regulatory objectives of the credit institution. This ensures that the model aligns with the institution's goals of minimizing losses from loan defaults while maximizing loan approvals for creditworthy customers. Additionally, regulatory considerations are integrated to ensure the model supports sustainable lending practices. In the Data Understanding phase, the dataset is explored to understand its structure, identify missing values, and gain initial insights into key variables such as credit score, income, and loan amount. Exploratory Data Analysis (EDA) techniques, including data visualization and correlation analysis, will be employed to uncover patterns and relationships within the data.

The Data Preparation phase involves cleaning and transforming the dataset to make it suitable for modelling. This includes handling missing values, encoding categorical variables, and normalizing features. The goal is to create a clean and relevant dataset that is optimized for predictive modelling. Next, in the Modelling phase, various modelling techniques, such as Navie Bayes, Gradient Boosting, Linear Discriminant Analysis, Decision Trees, Logistic Regression, and Random Forest, will be applied to build predictive models. Experiments will be conducted to determine the most effective model based on factors like accuracy, interpretability, and computational efficiency.

The Evaluation phase involves assessing the performance of the predictive models using metrics like precision, recall, accuracy, AUC-score and F1 score. Back testing with historical data will be performed to evaluate the model's predictive accuracy and robustness. Finally, in the Deployment phase, the validated predictive model will be integrated into the institution's operations through a web-based interface, allowing for real-time predictions on new customer data. This integration directly influences loan approval decisions and risk management strategies. The entire process will be documented in a comprehensive report, and continuous monitoring of the deployed model will ensure its ongoing effectiveness.

Process Flowchart and Implementation

Diagrammatic flow chart of the proposed methodology.

The process flowchart illustrates the high-level steps involved in the development of the Loan Default Predictor. This flowchart is designed to provide a clear overview of the entire process, from data preprocessing to model deployment.