Credit Rating Analysis with Support
Vector Machines and Neural
Networks:
A Market Comparative Study
Zan Huang, Hsinchun Chen,
Chia-jung Hsu, Andy Chen,
Soushan Wu
AI Seminar
Artificial Intelligence Lab
The University of Arizona
08/16/2002
Agenda
•
•
•
•
•
•
•
•
Introduction
Credit Risk Analysis
Literature Review
Research Questions
Analytical Methods
Data Sets
Experiments Results and Analysis
Discussion and Future Directions
Introduction
Credit Rating
• Credit Rating is valuable information
– Widely used measure for the riskiness of the
companies and bonds
• Credit Rating is expensive information
– Costly to obtain
• Credit Rating prediction is important
– For investors: estimate riskiness of unrated
companies
– For companies: monitor the companies’ credit
rating, predict the future rating.
Credit Rating Prediction
• Rating agencies: subjective judgment is
important, not predictable.
• Researchers: satisfactory results have been
obtained using statistical and AI methods.
• Prediction Assumption
– Risk evaluation expertise embedded in historical
rating data
• Beyond Prediction
– Interpretation of models  Market characteristics
Our Study
• Apply a relatively new machine learning
technique, Support Vector Machines,
with a classic technique, Neural
Networks
• Interpretation of the model
– Variable contribution analysis
• Cross market analysis
– United States and Taiwan market
Credit Risk Analysis
Credit Rating
• Two types of ratings
– Debt issue rating – bond rating, issue credit rating
– Debt issuer rating – conterparty credit rating, default
rating, issuer credit rating.
• Significant implication for investment
community
– Interest yield of the debt issue
– Investment regulation (“investment” level ratings)
– Conveys information about the value of the firm
Credit Rating Process
• Typical process
– Issuing company contacts rating agency
requesting rating
– Issuing company submits evaluation package
– Rating agency form evaluation team
– Evaluation team submits rating report
– Rating committee makes final decision
• Time and labor intensive
• Emphasizes on subjective judgment of
financial analyst and rating committee
members
Literature Review:
Bond Rating Prediction
Statistical Methods
• Ordinary Least Squares (OLS)
– Fisher 1959, Horrigan 1966, Pogue 1969, West 1970
• Multiple Discriminant Analysis (MDA)
– Pinches and Mingo 1973,1975
• Logistic Regression Analysis
– Ederington 1985
• Probit Analysis
– Gentry 1988, Jackson
• Prediction Accuracy: 50 – 70%
• Frequently used financial variables
– measures of size, financial leverage, long-term capital
intensiveness, return on investment, short-term capital
intensiveness, earnings stability and debt coverage stability
Statistical Methods (cont.)
• General Conclusion
– A simple model with a small list of financial
variables could classify about two-thirds of a
holdout sample of bonds
• Statistical Models
– Succinct and easy to explain
– Problem: Violation of multivariate normality
assumptions for independent variables
Artificial Intelligence Methods
• Trade-off between explanatory power and
interpretability of the models
• Statistical methods
– Simple model, under-fit the data
• Artificial Intelligence methods
– Increased model size (complexity of the models)
– Higher prediction accuracy (possible data overfitting)
– Difficult to interpret
Artificial Intelligence Methods (cont.)
•
•
•
•
Neural networks
Rule-based systems
Inductive Learning/Decision Trees
Case-based reasoning system
Artificial Intelligence Methods (cont.)
S tudy
D utta and
S hekhar
1988
S ingleton
and S urkan
1990
G arw aglia
1991
K im 1993
M oody and
U tans 1995
B ond rating
categories
M ethod
A ccuracy
2 (AA vs.nonAA)
BP
83.30%
2 (Aaa vs.A1,
A2 or A3)
BP
88%
3
BP
84.90%
55.17% (B P )
31.03% (R B S )
6
B P ,R B S
16
BP
S am ple
size
B enchm ark
statistical
m ethods
US
U S (B ell
com panie
s)
30/17
LinR
(64.7% )
126
M D A (39% )
U S SP
797
N /A
LinR (36.21% ),
M D A (36.20% ),
D ata
U S S&P
36.2% ,63.8% (5
classes),
85.2% (3 classes) U S S & P
110/58/60 LogR (43.10% )
N /A
N /A
Artificial Intelligence Methods (cont.)
S tudy
M aher and
S en 1997
K w on etal.
1997
K w on and
Lim 1998
C haveesuk et
al.1999
S hin and H an
2001
B ond rating
categories
6
5
5
6
5
M ethod
A ccuracy
70% (7),66.67%
BP
(5)
BP
71-73% (w ith
O P P ),66-67%
(w ith O P P ) (w ithoutO P P )
59.9% (AC LS ),
AC LS ,B P
72.7%
5% (B P ),
)
56.
B P ,R B F,
38.3% (R B F),
LVQ
36.7% (LVQ )
75.5% (C B R ,G A
com bined)
62.0% (C B R )
C B R ,G A
53-54% (ID 3)
D ata
S am ple
size
US
M oody's
299
B enchm ark
statistical
m ethods
LogR
(61.66% ),M D A
(58-61% )
K orean
126
M D A (58-62% )
K orean
60/126
60 (10
for each
category)
M D A (61.6% )
LogR
(53.3% )
3886
M D A (58.461.6% )
U S S&P
K orean
BP: Backpropagation Neural Networks, RBS: Rule-based System, ACLS: Analog Concept Learning System,
RBF: Radial Basis Function, LVQ: Learning Vector Quantization, CBR: Case-based Reasoning, GA: Genetic
Algorithm, MDA: Multiple Discriminant Analysis, LinR: Linear Regression, LogR: Logistic Regression, OPP:
Ordinary Pairwise Partitioning. Sample size: Training/tuning/testing.
Artificial Intelligence Methods (cont.)
• General Conclusion
– Neural networks have been the most frequently used
method.
– Neural networks outperformed conventional statistical
methods and inductive learning methods.
• Assessment of the accuracy of previous studies
needs to be adjusted by number of prediction
classes
– 5-class prediction accuracy: 55 – 75%
• Wide range of financial variables and sample sizes
– Number of financial variables: 7 – 87
– Sample sizes: 47 - 3886
• United States market and Korean market
Research Questions
Research Questions
• Explanatory power
– Whether applying a relatively new machine
learning techniques, Support Vector Machines,
will improve the credit rating prediction accuracy?
• Interpretability
– Can we provide analysis to increase the
interpretability of Artificial Intelligence methods
and try to extract more information about the
market characteristics from Artificial Intelligence
models?
– Can we use Artificial Intelligence models to
compare the characteristics of different financial
market?
Analytical Methods
Backpropagation Neural Network
• Most frequently used and best-performance
method in the literature
• Different network architectures have been
tried
– Number of hidden layers, number of hidden
nodes
• Used a standard three-layer fully connected
backpropagation neural network
– Number of hidden nodes: (number of input nodes +
number of output nodes)/2
Support Vector Machines
• Introduced by Vapnik in 1995
• Based on Structural Risk Minimization
principle from computational learning theory
• SVM is positioned at the intersection of
learning theory and practice
– “it contains a large class of neural nets, radial basis
function (RBF) nets, and polynomial classifiers as
special cases. Yet it is simple enough to be analyzed
mathematically, because it can be shown to correspond
to a linear method in a high-dimensional feature space
nonlinearly related to input space.” – Hearst 1998
Support Vector Machines (cont.)
• A good candidate for combining the strengths
of more theory-driven statistical methods and
more data-driven machine learning methods
• Empirical evidence
– Excellent generalization performance in a wide
range of problems (Bioinformatics, text
categorization, image detection, etc.)
• Has not been applied to the credit rating
prediction problem
• Multi-class SVM
– Hsu and Lin 2002, BSVM package
Data Sets
Taiwan Data Set
• Taiwan Ratings Corporation
– Established in 1997, partnering with Standard &
Poor’s.
• Securities and Futures Institute
– Quarter financial statement, financial ratios of
publicly traded companies
• Data Preparation
– Used the credit rating and the company’s financial
variables 2 quarters before the rating releasing
date
– 74 data points, 21 financial variables, 25 financial
institutes, 1998-2002
United States Data Set
• A comparable US data set from Standard & Poor’s
Compustat
– Comparable financial variables
– S&P senior debt rating for all commercial banks (DNUM
6021)
– 36 commercial banks, 265 data points, 1991-2000.
TW data
twAAA
twAA
twA
twBBB
twBB
Total
8
11
31
23
1
74
US data
AA
A
BBB
BB
B
Total
20
181
56
7
1
265
Variable Selection
• ANOVA test
– Whether the differences of each financial variable
among different rating classes were significant.
– 5 uninformative variables removed from the data
set
• Final data sets
– Taiwan: 14 financial ratios and 2 balance
measures
– United States: 12 financial ratios and 2 balance
measures
Financial Variables
X1
X2
X3
X4
X5
X6
X7
X8
X9
X10
X11
X12
X13
X14
X15
X16
X17
X18
X19
X20
X21
Financial Ratio Name/ Description
Total assets
Total liabilities
Long-term debts/ total invested capital
Debt ratio
Current ratio
Times interest earned (EBIT/interest)
Operating profit margin
(Shareholders’ equity + long-term debt)/ fixed assets
Quick ratio
Return on total assets
Return on equity
Operating income/ received capitals
Net income before tax/ received capitals
Net profit margin
Earnings per share
Gross profit margin
Non-operating income/ sales
Net income before tax/ sales
Cash flow from operating activities/ current liabilities
(Cash flow from operating activities / (capital expenditures +
increased in inventory + cash dividends)) in last 5 years
(Cash flow from operating activities – cash dividends)/ (fixed
assets + other assets + working capitals)
ANOVA BetweenGroup P-Value
0
0
0.12
0
0.36
0
0
0
0.37
0.01
0.04
0
0
0
0
0.02
0.81
0
0.84
0.64
0.08
Experiment Results and Analysis
Experiment Results
• 4 Models (Frequently used variables, full set
of variables)
– TW I: Rating = f(X1,X2,X3,X4,X6,X7)
– TW II: Rating = f(X1, X2, X3, X4, X6, X7, X8, X10, X11,
X12, X13, X14, X15, X16, X18, X21)
– US I: Rating = f(X1,X2,X3,X6,X7)
– US II: Rating = f(X1, X2, X3, X6, X7, X8, X10, X11, X12,
X13, X14, X15, X16, X21)
Experiment Results (cont.)
• Results
– SVM did not
outperform neural
networks.
– The small set of
frequently used
financial variables
contained most
relevant
information.
TW I
TW II
US I
US II
SVM Results
79.73%
77.03%
78.87%
80.00%
NN Results
75.68%
75.68%
80.00%
79.25%
Difference
4.05%
1.35%
-1.13%
0.75%
Experiment Results
81.00%
80.00%
79.00%
78.00%
SVM Results
77.00%
76.00%
75.00%
NN Results
74.00%
73.00%
TW I
TW II
US I
US II
Within-1-class accuracy
Predicted Rating
Predicted Rating
Acutal
Rating
twBB
Acutal
Rating
twAAA
twAA
twA
twBBB
twAAA
twAA
twA
twBBB
twBB
twAAA
7
0
1
0
0
twAAA
5
0
2
1
0
twAA
0
10
1
0
0
twAA
0
9
2
0
0
twA
4
1
23
3
0
twA
2
4
22
2
0
twBBB
1
0
6
16
0
twBBB
0
0
5
17
1
twBB
0
0
0
1
0
twBB
0
0
0
1
0
TW I: within-1-class accuracy: 91.89%
TW II: within-1-class accuracy: 93.24%
Predicted Rating
Acutal
Rating
Predicted Rating
AA
A
BBB
BB
B
Acutal
Rating
AA
0
20
0
0
0
A
0
178
3
0
BBB
0
23
33
BB
0
2
B
0
0
AA
A
BBB
BB
B
AA
6
13
1
0
0
0
A
2
165
12
2
0
0
0
BBB
0
16
37
2
1
5
0
0
BB
0
0
0
2
3
1
0
0
B
0
0
0
4
1
US I: within-1-class accuracy: 97.74%
US II: within-1-class accuracy: 98.44%
Variable Contribution Analysis
• Research of credit rating prediction using
Artificial Intelligence methods has been
solely focused on prediction accuracy.
• Low level understanding of the market
– Credit rating analyst rate companies (consciously
or unconsciously) based on a specific set of
financial variables
• Higher level understanding
– What are the relative importance of individual
financial variables in the process of credit rating?
- Variable Contribution Analysis
Variable Contribution Analysis (cont.)
• Difficult for both Neural Networks and Support Vector
Machines
• Substantial literature in interpreting neural network
models
– Mainly extracts information from the connection strengths
(inter-layer weights) of neural network model
– Measures of relative importance – Garson 1991, Yoon 1994
– Symbolic rules derived from connection weights – Taha 1999
– Optimal neural network structure construction and better
understanding of the models - Engelbrecht 1998
Measure of Relative Importance
• First order derivatives of the network
parameters
– Neural network model
 <y1, y2, …, yn>=f(<x1,x2, …, xm>)
– Contribution measure: yi / xj
• Garson 1991
– Without direction

Conik 
• Yoon 1994
– With direction
• Conik relative contribution of input i on out k
Connection strengths between input, hidden and output layers are
denoted as w ji and v jk .
| w ji || v jk |
J
j 1

I
i 1
 
| w ji |
| w ji || v jk |
I
J
i 1
j 1

I
i 1
w v


  w
| w ji |
J
Conik
j 1
ji
I
J
i 1
j 1
jk
ji
v jk
Variable Contribution Analysis
• Garson’s measure
• Optimal set of variables for the two markets
– TW III: Rating = f(X1, X2, X3, X4, X6, X7, X8)
– US III: Rating = f(X1, X2, X3, X4, X7, X11)
Financial Variable Name/ Description
X1
X2
X3
X4
X6
X7
X8
X11
Total assets
Total liabilities
Long-term debts/ total invested capital
Debt ratio
Times interest earned (EBIT/interest)
Operating profit margin
(Shareholders’ equity + long-term debt)/ fixed assets
Return on equity
Contribution Analysis Results
Variable Contribution (United States)
Variable Contribution (Taiw an)
0.3
0.3
AA
0.25
A
0.2
BBB
0.15
BB
0.1
B
0.05
Contribution Measure
Contribution Measure
0.35
0.25
tw AAA
0.2
tw AA
0.15
tw A
tw BBB
0.1
tw BB
0.05
0
0
X1
X2
X3
X4
X7
X11
X1
Financial Variable
X2
X3
X4
X6
X7
X8
Financial Varilables
Financial Variable Name/ Description
X1
X2
X3
X4
X6
X7
X8
X11
Total assets
Total liabilities
Long-term debts/ total invested capital
Debt ratio
Times interest earned (EBIT/interest)
Operating profit margin
(Shareholders’ equity + long-term debt)/ fixed assets
Return on equity
Cross Market Analysis
• US Model
– X1, X2, X3, X7 | X4, X11
– Most important: total assets, total liabilities,
long-term debts/total invested capital
• TW Model
– X4, X7, X8 | X1, X2, X3, X6
– Most important: operating profit margin, debt
ratio
Discussion and Future Directions
Discussion
• We need expertise from credit rating
industry to evaluate and interpret the
results
– Some positive response: “Size is not (that)
important in Taiwan.” – Dr. Soushan Wu
• The reason for the prediction accuracy
improvement over previous studies
• The reason for SVM’s failure to improve
Future Directions
• Data mining + text mining
– Add important financial variables from the
text format annual report
• Larger scale cross market analysis
– Mainland China, Taiwan, Hong Kong and
United States markets
• Multidimensional financial data
visualization and exploration