Loss Rate Forecasting Framework Based on Macroeconomic Changes: Application to US Credit Card Industry

TL;DR

This paper introduces a machine learning-based expert system that forecasts credit card charge-off rates by analyzing macroeconomic indicators, aiding industry practitioners in understanding economic impacts on losses.

Contribution

It develops two innovative macroeconomic-based forecasting models using machine learning, incorporating expert-selected indicators and lag structures for improved loss prediction accuracy.

Findings

Achieved low mean squared error in loss forecasting.

Selected macroeconomic indicators covering all economic sectors.

Demonstrated the model's ability to provide a holistic economic view.

Abstract

A major part of the balance sheets of the largest US banks consists of credit card portfolios. Hence, managing the charge-off rates is a vital task for the profitability of the credit card industry. Different macroeconomic conditions affect individuals' behavior in paying down their debts. In this paper, we propose an expert system for loss forecasting in the credit card industry using macroeconomic indicators. We select the indicators based on a thorough review of the literature and experts' opinions covering all aspects of the economy, consumer, business, and government sectors. The state of the art machine learning models are used to develop the proposed expert system framework. We develop two versions of the forecasting expert system, which utilize different approaches to select between the lags added to each indicator. Among 19 macroeconomic indicators that were used as the input, six were used in the model with optimal lags, and seven indicators were selected by the model using all lags. The features that were selected by each of these models covered all three sectors of the economy. Using the charge-off data for the top 100 US banks ranked by assets from the first quarter of 1985 to the second quarter of 2019, we achieve mean squared error values of 1.15E-03 and 1.04E-03 using the model with optimal lags and the model with all lags, respectively. The proposed expert system gives a holistic view of the economy to the practitioners in the credit card industry and helps them to see the impact of different macroeconomic conditions on their future loss.