A DEEP LEARNING APPROACH Stefania Albanesi Domonkos F
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NBER WORKING PAPER SERIES PREDICTING CONSUMER DEFAULT: A DEEP LEARNING APPROACH Stefania Albanesi Domonkos F. Vamossy Working Paper 26165 http://www.nber.org/papers/w26165 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 2019 This research was supported by the National Science Foundation under Grant No. SES 1824321. This research was also supported in part by the University of Pittsburgh Center for Research Computing through the resources provided. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2019 by Stefania Albanesi and Domonkos F. Vamossy. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Predicting Consumer Default: A Deep Learning Approach Stefania Albanesi and Domonkos F. Vamossy NBER Working Paper No. 26165 August 2019 JEL No. C45,C55,D14,D18,E44,G0,G2 ABSTRACT We develop a model to predict consumer default based on deep learning. We show that the model consistently outperforms standard credit scoring models, even though it uses the same data. Our model is interpretable and is able to provide a score to a larger class of borrowers relative to standard credit scoring models while accurately tracking variations in systemic risk. We argue that these properties can provide valuable insights for the design of policies targeted at reducing consumer default and alleviating its burden on borrowers and lenders, as well as macroprudential regulation. Stefania Albanesi Department of Economics University of Pittsburgh 4901 Wesley W. Posvar Hall Pittsburgh, PA 15260 and CEPR and also NBER [email protected] Domonkos F. Vamossy Department of Economics University of Pittsburgh 230 S Bouquet St Pittsburgh, PA 15260 [email protected] 1 Introduction The dramatic growth in household borrowing since the early 1980s has increased the macroeconomic impact of consumer default. Figure 1 displays total consumer credit balances in millions of 2018 USD and the delinquency rate on consumer loans starting in 1985. The delinquency rate mostly fluctuates between 3 and 4%, except at the height of the Great Recession when it reached a peak of over 5%, and in its aftermath when it dropped to a low of 2%. With the rise in consumer debt, variations in the delinquency rate have an ever larger impact on household and financial firm balances sheets. Understanding the determinants of consumer default and predicting its variation over time and across types of consumers can not only improve the allocation of credit, but also lead to important insights for the design of policies aimed at preventing consumer default or alleviating its effects on borrowers and lenders. They are also critical for macroprudential policies, as they can assist with the assessment of the impact of consumer credit on the fragility of the financial system. (a) Total consumer credit balances (b) Delinquency rate on consumer loans Figure 1: Source: Author's calculations based on Federal Reserve Board data. This paper proposes a novel approach to predicting consumer default based on deep learning. We rely on deep learning as this methodology is specifically designed for prediction in environments with high dimensional data and complicated non-linear patterns of interaction among factors affecting the outcome of interest, for which standard regression approaches perform poorly. Our methodology uses the same information as standard credit scoring models, which are one of the most important factors in the allocation of consumer credit. We show that our model substantially improves the accuracy of default predictions while increasing transparency and accountability. It is also able to track variations in systemic risk, and is able to identify the most important factors driving defaults and how they change over time. Finally, we show that adopting our model can accrue substantial savings to borrowers and lenders. Credit scores constitute one of the most important factors in the allocation of consumer credit 1 in the United States. They are proprietary measures designed to rank borrowers based on their probability of future default. Specifically, they target the probability of a 90days past due delin- quency in the next 24 months.1 Despite their ubiquitous use in the financial industry, there is very little information on credit scores, and emerging evidence suggests that as currently formulated credit scores have severe limitations. For example, Albanesi, De Giorgi, and Nosal (2017) show that during the 2007-2009 housing crisis there was a marked rise in mortgage delinquencies and foreclosures among high credit score borrowers, suggesting that credit scoring models at the time did not accurately reflect the probability of default for these borrowers. Additionally, it is well known that credit scores and indiscriminately low for young borrowers, and a substantial fraction of borrowers are unscored, which prevents them from accessing conventional forms of consumer credit. The Fair Credit Reporting Act, a legislation passed in 1970, and the Equal Opportunity in Credit Access Act of 1984 regulate credit scores and in particular determine which information can be included and must be excluded in credit scoring models. Such models can incorporate information in a borrower's credit report, except age and location. These restrictions are intended to prevent discrimination by age and factors related to location, such as race.2 The law also mandates that entities that provide credit scores make public the four most important factors affecting scores. In marketing information, these are reported to be length of credit history, which is stated to explain about 15% of variation in credit scores, and credit utilization, number and variety of the debt products and inquiries, each stated to explain about 25-30% of the variation in credit scores. Other than this, there is very little public information on credit scoring models, though several services are now available that allow consumers to simulate how various scenarios, such as paying off balances or taking out new loans, will affect their scores. The purpose of our analysis is to propose a model to predict consumer default that uses the same data as conventional credit scoring models, improves on their performance, benefiting both lenders and borrowers, and provides more transparency and accountability. To do so, we resort to deep learning, a type of machine learning ideally suited to high dimensional data, such as that available in consumer credit reports.3 Our model uses inputs as features, such as debt balances and number of trades, delinquency information, and attributes related to the length of a borrower's credit history, to produce an individualized estimate that can be interpreted as a probability of default. We target the same default outcome as conventional credit scoring models, namely a 90+ days delinquency in the subsequent 8 quarters. For most of the analysis, we train the model on data 1The most commonly known is the FICO score, developed by the FICO corporation and launched in 1989. The three credit reporting companies or CRCs, Equifax, Experian and TransUnion have also partnered to produce VantageScore, an alternative score, which was launched in 2006. Credit scoring models are updated regularly. More information on credit scores is reported in Section 6.1 and Appendix E. 2Credit scoring models are also restricted by law from using information on race, color, gender, religion, marital status, salary, occupation, title, employer, employment history, nationality. 3For excellent reviews of how machine learning can be applied in economics, see Mullainathan and Spiess (2017) and Athey and Imbens (2019). 2 for one quarter and test it on data 8 quarters ahead, in keeping with the default outcome we are considering, so that our predictions are truly out of sample. We present a variety of performance metrics suggesting that our model has very strong predictive ability. Accuracy, that is percent of observations correctly classified, is above 86% for all periods in our sample, and the AUC-Score, a commonly used metric in machine learning, is always above 92%. To better assess the validity of our approach, we compare our deep learning model to logistic regression and a number of other machine learning models. Deep learning models feature multiple hidden layers, designed to capture multi-dimensional feature interactions. By contrast, logistic regression can be interpreted as a neural network without any hidden layers. Our results suggest that deep learning is necessary to capture the complexity associated with default behavior, since all deep models perform substantially better than logistic regression. The importance of feature interaction reflects the complexity associated with default behavior. Additionally, our optimized model combines a deep neural network and gradient boosting and outperforms other machine learning models, such as random forests and decision trees, as well as deep neural networks and gradient boosting in isolation. However, all approaches show much stronger performance than logistic regression, suggesting that the main advantage is the adoption of a deep