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INTRODUCTION
1.1 Background of study
Credit-Risk analysis and evaluation is an extremely difficult and essential information
mining issue in the area of monetary investigation. One of the key choices financial
institutions need to make is to choose whether or not to grant loan to a customer. This
choice essentially comes down to a double arrangement issue which goes for recognizing
great payer from terrible payers. Up to this point, this qualification was made utilizing a
judgmental methodology by simply assessing the application form and details of the
applicant. The credit master then chooses the financial soundness of the candidate,
utilizing all conceivable important data concerning his/her socio-demographic status,
monetary conditions and intensions. The coming of data storage technology has
encouraged financial organizations capacity to store all data in regards to the attributes
and reimbursement conduct of credit applicants electronically. This has persuaded the
need to robotize the credit-granting decision by using machining-learning algorithm or
artificial neural networks.
Various techniques have been proposed in the literature to create credit-risk analysis
and evaluation models, these model include Neural network models. The greater part of
these studies concentrate essentially on creating classification models with high prescient
precision without giving careful consideration to clarifying how the classification are
being made. Clearly, this assumes a crucial part in credit-risk analysis and evaluation, as
the evaluator might be required to give a legitimization for why a specific credit
application is affirmed or rejected. Capon (1999) was one of the first authors to argue that
credit-risk analysis and evaluation system should focus more on providing explanations
for why customers default instead of merely trying to develop score cards which
accurately distinguish good customers from bad customers.
Financial institutions such as banks, renting organizations, venture and annuity assets are
liable to money related danger. The fundamental dangers are: Credit, Market, Liquidity
and Operational risk. To diminished credit risk, financial institutions play out a financial
investigation of every potential borrower.
In this exploration work, I provide details regarding the utilization of Artificial Neural
Network standard extraction technique to develop intelligent and self-explanatory credit-
risk analysis and evaluation system. Although manufactured artificial neural network has
been utilized before for this reason, there is still no accord on their prevalence with
deference over more conventional measurable calculations, for example, logistic
regression. This alludes to the way that they don't permit formalization of the relationship
between the output and the inputs in an easy to use, understandable way.
2.1 Introduction
This chapter reviews what other people have done on this topic and related topics. In this
chapter also the concept of neural network shall be discussed including how neural
network will be applied in a loan evaluation. It is now an unarguable fact that all well-
structured organizations: businesses co-operate bodies, government agencies etc. are all
information technology (I.T) based. This has brought about a rapid increase in demand
for neural network developers
The pioneer of credit models was Henry Wells, executive of the Spiegel Inc. who
developed a credit-scoring model during the Second World War (Lewis, 1992). Wells
needed tools that would allow experienced analysts to perform credit evaluation, because
many of its qualified employees had been recruited for the War. During the fifties the
scoring models were disseminated in the American banking industry. The first models
were based upon pre-established or eights for certain given characteristics, summing the
points to reach a classification score. More extensive use of the models in the sixties
transformed business only companies in the financial area, but also the large retailers
began to use credit scoring models to carry out credit sales to their consumers. Retailers
Such as Wards, Blooming dales and J. C. Penney were some of the pioneers in this
segment.
Currently, about 90% of the American companies that offer some kind of consumer credit
utilize models of credit scoring. Other countries like Brazil, Portugal, and Nigeria etc.
their financial institutions started to make an intensive use of credit scoring models only
in the Mid-nineties.
Credit scoring is perhaps one of the most "classic" applications for predictive modeling
(Chen, 2002), to predict whether or not credit extended to an applicant will likely result
in profit or losses for the lending institution. Credit scoring is the set of decision models
and their underlying techniques that aid lenders in the granting of consumer credit. These
techniques determine who will get credit, how much credit they should get, and what
operational strategies will enhance the profitability of the borrowers to the lenders.
Further, they help to assess the risk in lending. Credit scoring is a dependable assessment
of a persons credit worthiness since it is based on actual data.
A lender commonly makes decisions: whether to grant credit to a new applicant, it is
critical that there is a large sample of previous customers with their application details,
behavioral patterns, and subsequent credit history available. Most of the techniques use
this sample to identify the connection between the characteristics of the consumers
(annual income, age, number of years in employment with their current employer, etc.)
and their subsequent history.
S= + +. +
There are some steps to be followed to construct a credit scoring models such as:
I. Survey of a historical background of the clients.
The basic supposition to construct a model of credit evaluation is that the clients
have the same behaviour pattern over time; therefore, models are constructed based
upon past information. The availability and quality of the data bank are
fundamental for the success of the model (Trevisani, 2004).
II. Classification of clients according to their behaviour pattern and definition of the
dependent variable. In practice, institutions consider only the good and bad clients
to build the model because it is much easier to work with binary response models.
This tendency to work only with good and band clients is also noticed in academic
works started by (Rosa, 2002).
III. Descriptive analysis and preparation of data. This consist of analyzing, according
to static criteria, each variable the will be utilized in the model.
IV. And finally choice and application of techniques to be used in the construction the
model, Neural Networks will be used in this work. Hard and Henley (1997) further
stress Discriminant Analysis, Regression and Decision Tress as methods that can
be used in practice. Recently some scholars have also used survival Analysis
(Harrison and Ansell: 2002). There is no method that is clearly better than the
others, everything depends upon how the elected techniques the data.
V. Selection and implementation of the best model. The best model is design using
the previously defined criteria. As such the implementation of the model must be
programmed. The institution must adjust its systems, to receive the final algorithm
and program its utilization in coordination with the other areas involved.
Credit risk can be moderated by enhancing the loan structure. Parties to a loan can arrange
for mitigants such as collated, guarantees, letters of credit, credit derivatives, and
insurance during or after the loan is underwritten.
Although these mitigants have similar effects there are important distinctive, including
the amount of loss protection, that must be considered when assigning risk ratings. For
example, a letters of credit may affect a loans risk rating differently than credit
derivative.
Credit miligants primarily affect loss when a guarantees, generally do not lessen the risk
of default. Therefore, their impact on a rating should be negligible until the loan is
classified. (Chia-Jung Hsu: 1999).
Collateral, the most human form of credit risk mitigation, is any asset that is pledged,
hypothecated, or assigned to lender and that the lender has the right to take possession of
it if the borrower defaults.
The lenders rights must be perfected through legal documents that provide a security
interest, mortgaged, deed of trusts, or other form of lien against the asset. The process of
perfecting the lenders interest varies by types of assets and by locality.
Once the lender has taken possession of the collateral, loan losses can be reduced or
eliminated through sale of the assets. The level of loss protection is a function of the
assets value, liquidity, and marketability. Realistic collateral valuation is important at
loan inception and throughout the loans life, but it becomes increasingly important as
the borrowers financial condition and performance deteriorate (Van-Zak:2001).
According to Van-Zak, collateral valuations should include analysis will the collateral be
with when it must be liquidated. The appropriate value may be a fair market, orderly
liquidation, or forced liquidation valuation, depending on the borrowers circumstances.
(Bishop and Watt: 2001).
Credit derivation can be used to manage capital manage loan portfolios. And mitigate
risk in individual transactions. Only credit derivatives for individual transactions have a
bearing on risk rating.
According to (Soushan and Wu: 2000) credit derivatives for individual loan transactions
are usually written. Credit derivatives have unique structural characteristics and
complexities that can diminish or eliminate their ability to reduce credit risk. In
determining how much a derivative enhances a credits rating (if indeed it does so at all),
examiners should determine whether the derivatives protection is compromised by any
of the following circumstances:
i) The event that triggers payments is tied to a reference asset that may have different
forms and conditions than the loan held by the financial institutions. The residual
exposure in this transaction is known as basis risk.
ii) The financial institutions have forward credit exposure because the derivative has
a shorter maturity than the financial institutions loan. A timing mismatch can also
occur when the protection does not take effect until some future date.
iii) The derivative has a materially clause that limits protection to amount over a
designated threshold. In other words, the financial institution retains the first loss
position.
iv) The definition of default or any other credit event that triggers the sellers payment
is less rigorous for the swap or the reference assets than for the financial institutions
loan. This is known as contract basis risk.
v) The protection seller is materially at risk of default. If this seller and the reference
asset are correlated (that is, if they are subject to many of the same economic and
market forces), the risk to the protection buyer increases.
Finally, language in credit derivatives contracts is complex and can be subjected to
different interpretations. (Soushan and Wu : 2000)
In this project among other credit risk system discussed earlier. It will be pertinent if a
brief review of the model that will be use in this work be looked into very shortly i.e.
(The artificial Neural Networks model).
Artificial Neural Networks (ANN) is computational techniques that represents a
mathematical model based upon the neural structure of intelligent organisms and who
acquire knowledge through experience. It was only in the eighties that, because of the
greater computational power, neural networks were orderly studied and applied.
(Faulsett: 1994) underlines the development of back propagation algorithm as the turning
point for the popularly of neural networks.
An artificial neural network model processes certain characteristics and produces replies
like those of the human brain.
Artificial neural networks are developed using mathematical model in which the
following suppositions are made.
Figure 2.6.1: The neural network layers for credit risk analysis and evaluation. Bakpo and
Kabari,( 2009).
The input units of the system have connexions starting but not in arriving, contrary to,
the output neurons that have connexions arriving and not starting. The hidden units have
connexions arriving from the input layer and continuing to the output neurons. The
proposed neural network architecture works in this way:
i. In the input layer, balance sheet data are inserted;
ii. In the hidden layer, it calculates the activation state of each neuron;
iii. The output layer expresses a result which is easy to interpret.
The most important quality of neural networks is the capacity to Learn according to the
environment and thereby improves their performance as stated by (Castro 2003).
There are essentially three type of learning.
(i) Supervised learning: In this type of learning the expected reply is indicated to the
network. This is the case of this work, where a priori it is already known whether
the client is good or bad.
(ii) Non- supervised learning: In this type of learning the network must only rely on
the received stimuli; the network must learn to cluster the stimuli;
(iii) Reinforcement learning: In this type of learning, behaviour of the network is
assessed by an external reviewer.
(Berry And Linoff: 1997) Point out the following positive points in the utilization of
neural networks:
1) There are versatile: neural networks may be used for the solution of different type
of problems such as: prediction, clustering or identification of patterns.
2) They are able to identify non-linear relationships between variables.
(iii)They are widely utilized, can be found in various software. As for the
disadvantages the authors state:
(iv)Results cannot be explained: no explicit rules are produced, analysis is performed
inside the network and only the result is supplied as the output.
(v)The network can converge towards a lesser solution: there are no warranties that
the network will find the best possible solution; it may converge to a local maximum.
(Fausett 1994).
CHAPTER THREE
3.1 Introduction
System analysis can be defined as the process of breaking down a whole entity into parts
or components for proper understanding. It involves studying a problem area and
constructing an improved way of handling it. It adopts a perspective approach to
information system development in that it specifies in advance the modules, stages and
tasks which have to be carried out the deliverables to be produced and furthermore the
techniques used to produce the deliverables.it can also be referred to as a process through
which an existing system is examined with the intention of improving it or creating a better
new system through better procedures and methods, An analysis is done by the designer in
order to better understand why computerization is necessary. It helps the designer to
breakdown complex topics to simpler form in order to get a better understanding of it. In
this chapter, the analysis of the old system of credit risk evaluation and analysis shall be
discussed. Also, the problem inherent in the old system shall be identified with the aim of
developing a new and better system. Finally, a new system which will solve the problems
identified in the old system will be designed
3.2 Methodology
We have many methodologies for software development; some of the most popular
software development methods include rapid application development, structured system
analysis and design method, integrated methodology, the prototype and others. The
methodology employed in the development of the proposed system is the object oriented
analysis and design method which is a model-driven technique that integrates data and
process into construct called object. OOADM also has the potential for object reusability.
Object models are diagrams that document a system in terms of its objects and their
relationships. During this phase, the class objects and the interrelationships of these
classes are translated and actually coded using the programming language decided upon.
The databases are made and the complete system is given a functional shape. The
complete OO methodology revolves around the objects identified in the system.
The researcher carried out a study of the present system with the IT supervisor of the
financial institution and found out that the present system that was being used by the
institution was the manual loan system.
Initial conversation
This is the first contact you will have with your Loan officer. We use this
stage to discuss your situation, your needs and objectives behind getting a loan.
Once you have agreed to apply for loan, you will be asked to compete our paper
application which contains data ranging from name, age, sex, marital status,
nationality, state of origin, Local government identification, email, annual income,
reason for loan, property type and name etc. We will also require supporting
documents such as your income details, documents. By giving us all supporting
documents in one go allows us to give you a quick and accurate assessment.
Preliminary assessment
After we have your application and supporting documents we are able to do a
preliminary assessment of your situation. The preliminary assessment is a very
detailed process where we identify any possible problems from a lending point of
view, also identify if there will be risk in the customer paying back the loan. If no
risk is identified the loan is granted.
3.3.1 Managers
Critical issues for the present system
According to the interviews carried out on Financial institution, it was found out that
most of the managers had been in the institution for a period of 3-4 years. When asked
about the number of loan given out, it was revealed that the institution gives out 3
categories of loans. These include Personal, Household equipment, commercial loans.it
was also paramount for the researcher to know the potential loan applicants. These are
people with good accounts, clients who get salaries through business community. When
asked about how they decide whom to give loan and whom not to give, it was revealed
that age of customers were considered, if his or her age falls below 20 they cannot risk
giving out loan to such customer, it was reviewed in the case of repeated customers, they
looked at their repayment history. If a client has ever defaulted the cannot risk giving a
loan but if he or she has been servicing the loan well, then the give the loan. For the case
of new customers, it is those ones with good performing businesses and good income,
work with a reputable establishment. In order for the researcher to get the requirements
for the proposed system, a question was asked about the features that are missing in the
existing system. 75% of the financial institution managers interviewed reviewed that that
the existing system makes work tiresome on the side of the manager who has to compute
them moreover after being computed by credit officers to check accuracy. If it is error
free, then a decision has to be taken on which is based on the result of the computations.
3.3.2 Credit Officers
Critical issues Registered by Loan officers
An interview with the loan officers regarding whether customers have ever complained
about the existing system, was answered with 100% response yes and the following are
some of the complaints raised.
I. Officers takes a lot of time (usually 1-2 months) right from the time a customer
applies up to the time a loan is approved.
II. Customer make unnecessary trips to the institution. This normally comes in if a
credit officer is not knowledgeable about the loan requirement where he tells a
customer to provide for example land title as security and when he brings it, again
he is told to pledge chattels. This disgusts customers as they have to make so many
trips because of failure of the officer to provide full and accurate information in
first meeting.
III. Amount of loan approved is far below the amount applied for and yet there is no
proper justification for that.
IV. No grace for business loan.
Out of many officers interviewed. Some were of the view that the existing system is
cumbersome as it contains repetitive fields and some particulars are irrelevant.
The same percentage also revealed that, there is a lot of bias in the existing system
because once you have a perception that someone is likely not to pay, then you do not
even bother to appraise. Among the solutions suggested were a Proper system to put in
place and the following policy and procedures
3.3.3 Observation
Various activities ranging from the distribution of reports, managers behavior in the
office, credit officers behavior in loan department and customer behavior with loan
officers were observed. This was to help the researcher become familiar with financial
institution operations. Observation further enabled the researcher crosscheck for the
validity and accuracy of the information that was gathered through interviews and also
acted as a foundation in designing an appropriate system.
3.4 Strength of the Present System:
i) Data loss is less of a risk, particularly if records are stored in a fire-proof
environment,
ii) It enhances personal relationship between the giver and the receiver.
iii) The risk of corrupted data is much less.
iv) The cost of establishing the system is cheaper
Artificial neural networks can be placed among those of dynamical systems with
processing the experimental data, knowledge beyond transmits data to the network.
Input1 Hidden1
Input k Hidden k
Where
() is the hidden value.
() is the input value.
is the transfer function.
Y(k) is the output value.
(i) The input layer: This represents the loan data attributes that will be inserted into
the proposed computerized system. Financial institution used different attribute
in processing credit data.
No Attribute Name
1 Age
2 Terms
3 Annual income
4 Number of years employed
5 Job
6 Property type
7 Reason for loan
8 Property name
9 Repayment period
10 Phone no
11 Present employment
12 Credit history
13 Loan amount
14 Loan date
(ii) The hidden layer: The hidden layer is a bridge between the input layer and the
output layer. The neurons in this layer are fundamentally hidden from view, and
their number and arrangement can typically be treated as a black box to those who
are carrying out the system. The function of the hidden layer is to process the input
variables. This is achieved by summing up all weighted inputs, checking whether
the sum meets the threshold value and applying the transformation function. The
weights between the input neuron and hidden neurons determine when each unit
in the hidden layer may fire or not and by modifying these weights, the hidden
layer may fire or not in other words, the hidden layers learn the relationship
between inputs and outputs in a way similar to that of the human brain by adjusting
the weights during the training process. It is in the hidden layer that neural network
rules are set that detects fraudulent customer base on under age, with low income
rate, to check credit history with institution, to check types of job be done by the
customer etc. this is done in order to minimize credit risk in loan granting
(iii) The output layer This layer expresses the result of the Process layer by
bringing out result from the decisions and rules being set in the hidden layer
determining if to grant loan to customer or not to grant loan.
Start
Loan form
application
No Accepted
perfomance
Yes
Loan grant
End
Enter Username
Enter Email-id
Enter Password
Sign-Up
Login page: The login system is shown in the figure below. The login page is designed
with a Php backend. The User enters his username and password and clicks on the sign
in button, the system processes the data entered and the result is to grant access into the
loan portal homepage.
Username
Password
Sign-in
Loan application page: The loan application page form is designed with a Php backend
that enables the client details to be collected and processed with neural network principles
before determining if he/her is credit worthy or not.
Phone no Email
Submit
3.8 Information and product flow diagram
User
System should have a Provision for client to contact help desk by contact form or
email.
System should have a facility for client and financial institution administrators to
view all loan application
System should have the provision for client to access knowledgebase which details
problem and solutions.
System should provide facility for client to give feedback.
Non-functional Requirements
The users of the system should be provided user id and password along with well-
defined access privileges.
24X7 internet connectivity should be provided for well-functioning of the system.
System should be provided with proper backup media and resources to handles
data crash scenarios.
3.10 High level model of the proposed system
User
Program interface
Login Sign-up
Homepage
Loan
View loan
Application
Database