Credit Risk Modelling Using RNN-LSTM Hybrid Model for Digital Financial Institutions

Abstract

In response to the rapidly evolving financial market and the escalating concern surrounding credit risk in digital financial institutions, this project addresses the urgency for accurate credit risk prediction models. Traditional methods such as Neural network models, kernel-based virtual machines, Z-score, and Logit (logistic regression model) have all been used, but their results have proven less than satisfactory. The project focuses on developing a credit scoring model specifically tailored for digital financial institutions, by leveraging a hybrid model that combines long short-term memory (LSTM) networks with recurrent neural networks (RNN). This innovative approach capitalizes on the strengths of the Long-Short Term Memory (LSTM) for long-term predictions and Recurrent Neural Network (RNN) for its recurrent neural network capabilities. A key component of the approach is feature selection, which entails extracting a subset of pertinent features from the credit risk data using RNN in order to help classify loan applications. The researcher chose to use data from Kaggle to study and compare the efficacy of different models. The findings reveal that the RNN-LSTM hybrid model outperforms other RNNs, LSTMs, and traditional models. Specifically, the hybrid model demonstrated distinct advantages, showcasing higher accuracy and a superior Area Under the Curve (AUC) compared to individual RNN and LSTM models. While RNN and LSTM models exhibited slightly lower accuracy individually, their combination in the hybrid model proved to be the optimal choice. In summary, the RNN-LSTM hybrid model developed stands out as the most effective solution for predicting credit risk in digital financial institutions, surpassing the performance of standalone RNN and LSTM models as well as traditional methodologies. This research contributes valuable insights for banks, regulators, and investors seeking robust credit risk assessment tools in the dynamic landscape of digital finance.