Technological Forecasting & Social Change 161 (2020) 120309

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Technological Forecasting & Social Change

journal homepage: www.elsevier.com/locate/techfore

Machine learning and credit ratings prediction in the age of fourth industrial T
revolution
Jing-Ping Lia, Nawazish Mirzab, Birjees Rahatc, Deping Xiongd,
⁎

a
Professor of Finance, School of Finance, Shanxi University of Finance and Economics, Taiyuan, China
b
Associate Professor of Finance, La Rochelle Business School – Excelia Group, La Rochelle, France
c
Adjunct Faculty of Finance, La Rochelle Business School – Excelia Group, La Rochelle, France
d
Professor of Finance, School of Finance, Yunnan University of Finance and Economics, Kunming, Yunnan, China

ARTICLE INFO ABSTRACT

Keywords: The fourth industrial revolution has resulted in unprecedented innovations and improvements for the financial
Fourth industrial revolution sector. In this paper, we employ the machine learning techniques- a subset of artificial intelligence- in order to
Machine learning predict the credit ratings for the banks in GCC. The quarterly dataset of the macro and bank specific variables
Credit Ratings was used for a period that spanned between the years 2010 to 2018, with an out of sample prediction, for three
Risk Assessment
years. Our findings suggest that arbitrary forests demonstrate the highest precision, based on the F1 score,
specificity, and the accuracy scores. This precision remained robust for all the classes of the ratings, ranging from
JEL Classifications:
the highest credit quality to the default mode as well. Moreover, our findings also revealed that the Artificial
G21
G32 Neural Networks are ranked second for the overall predictions that have been made. However, for the spec­
O30 ulative and default grades, our findings suggest that the Classification and Regression Trees (CART) are sig­
O33 nificantly relevant, and although their precision is less than the random forests, the difference is not significant.
Therefore, we propose that, for the stressed banks, both random forests and the CART should be employed, for a
better and more informed risk assessment. These findings have important implications, especially when it comes
to analyzing the credit risk of the banks.

1. Introduction potential biases, enabling better assessments and decision making.

The fourth industrial revolution has significantly transformed the
way financial systems work. Although each industrial revolution
brought unique changes to the global scenario, the speed at which the
fourth revolution is impacting the businesses is, by far, unprecedented
(Su et al., 2020b; Xu et al., 2018). The swift adaption of technology is
considered to be a complex and intricate phenomenon, with both op­
portunities and challenges that are put forth towards the financial
sector. The innovative technologies, like artificial intelligence, big data,
block chain and machine learning, are redesigning the payment solu­
tions, investment management, and the risk assessment as well. On the
flip side, issues of data security, privacy, varied customer experience
and regulatory compliance have also become considerably convoluted
with the advent of technological advancements.
Machine learning is a subset of artificial intelligence, which employs
statistical techniques to train machines from a defined dataset. From
this learning, the systems generate optimized models that best explain
the data. This avoids the use of exogenous assumptions, and limits the
Therefore, these models are widely used for forecasts and predictions as
well (Wang et al., 2020), (Lee et al., 2014). Given the strength of the
underlying algorithms, the use of machine learning, in order to explore
the pertinent financial issues has experienced an increase. (Gan et al.,
2020) explored the asset and option pricing with machine learning
models and argued in favor of their superior performance as compared
to the conventional methods. (Tang et al., 2019) also reported a higher
incidence of accuracy from the machine learning models, in measuring
the credit risk of the energy industry in China. Similar accuracy has
been documented by (Buehler et al., 2019), (Weigand, 2019) and
(Ban et al., 2018) for various financial applications as well. Moreover,
(Barboza et al., 2017) also used these techniques for bankruptcy pre­
dictions, while (Butaru et al., 2016) applied the machine learning al­
gorithms for credit card risk management. It is worth noting that there
are many studies which employ conventional parametric, and non-
parametric methods to forecast the credit risk, and the credit ratings. In
the same context, (Pasiouras et al., 2007) applied a discriminant ana­
lysis on a sample of Asian banks, in order to validate the ratings

⁎
Corresponding author.
E-mail addresses: elahimn@excelia-group.com (N. Mirza), rahatb@excelia-group.com (B. Rahat), depingxiong@hotmail.com (D. Xiong).

https://doi.org/10.1016/j.techfore.2020.120309
Received 29 April 2020; Received in revised form 3 September 2020; Accepted 5 September 2020
0040-1625/ © 2020 Elsevier Inc. All rights reserved.
J.-P. Li, et al.
assigned by Fitch. (Gogas et al., 2014) also used an ordered probit re­
gression framework to forecast the credit ratings of the banks in the US.
Additionally, (Öǧüt et al., 2012) predicted the banks’ financial strength
ratings by employing an ordered logistic regression. However, the
precision of these methods have remained questionable, and as noted
by (Kumar and Bhattacharya, 2006), the machine learning models are
better suited for complex data and their precision outperforms the
conventional methods.
The forecasting precision of the machine learning models have
motivated us to apply them for the prediction of the credit ratings of the
banks that are members of the Gulf Cooperation Council (GCC). These
ratings are independent opinions about a bank's repayment capacity,
expressed by specialized credit ratings agencies. These opinions are
driven by an intricate as well as due diligent process due to the re­
putational concerns of these agencies (Bar-Isaac and Shapiro, 2013).
Moreover, some researchers also believe that these ratings are primarily
an assessment of the quality of the credit (Poon, 2003). However, they
may impact the other aspects as well, such as the choice of capital
structure (Kisgen, 2006), stock liquidity (Odders-White and
Ready, 2006), IPO pricing (An and Chan, 2008), business diversifica­
tion (Chou and Cheng, 2012) and the corporate social responsibility.
Therefore, determining an optimal model to access the most precise
credit ratings forecast will have significant implications for the banks.
The GCC region comprises of seven countries, namely Bahrain,
Kingdom of Saudi Arabia (KSA), Qatar, Kuwait, United Arab Emirates
(UAE) and Oman. These are, primarily, oil producing countries that
have been trying to diversify their revenues, amidst the high volatility
of the oil prices. Although, their GDP is relatively high, but owing to
structural issues, these countries are still classified as emerging markets.
Consequently, there have been constant financial reforms aimed to­
wards bringing financial stability in the banking sector
(Abuzayed et al., 2018). With the slow economic growth in the past few
years, the GCC banking sector reported a 2% growth in 2019. Hence,
we can concur that the credit growth remains limited due to the pru­
dent focus on lending. Most of the banks in the region are rated by the
big three,1 and the Capital Intelligence rating agency. Moreover, the
local banks are well capitalized with adequate profitability, and strin­
gent supervision (Khediri et al., 2015). However, the asset quality is
sometimes volatile due to the economic reliance on petrochemicals and
the political uncertainties. This makes these banks an interesting case to
assess, and use the power of machine learning in order to predict their
credit quality.
The rest of the paper is organized as follows. We have introduced
the concept of credit ratings in Section 2. Section 3 will explain the
ratings criteria used in our paper for predictive models, while Section 4
elaborates the machine learning techniques. Moving on, Section 5
highlights data and methodology, whereas the results are presented in
Section 6. Lastly, Section 7 concludes the study.
2. Introduction to credit ratings
In a crux, credit ratings are forward looking opinions about the
relative credit worthiness of an obligor. These opinions stem from
rating methodologies and criterion, which are analyzed and revised on
a continuous basis. General ratings express an opinion about the will­
ingness and ability of a borrower to meet their financial obligations on
time, and that too, in full. Specific ratings relate to the credit quality,
and the probability of default that pertains to individual debt issues
such as corporate notes, corporate, as well as government bonds, or
mortgage backed securities. These ratings can be issued for different
types of borrowers that include individuals, corporations, sovereigns
and sub sovereign entities.
Certain key factors hold critical importance in the context of credit
1
Standard and Poor's, Moody's and Fitch.
2
Technological Forecasting & Social Change 161 (2020) 120309
ratings. Ratings are strictly an opinion, and cannot be labeled as being
accurate or inaccurate. While all the rating agencies’ credit ratings re­
volve around the credit risk associated to the entity that is being rated,
the factors incorporated, as well as the relative importance assigned,
and the process, may vary. This is why users of credit ratings are en­
couraged to refer to the definitions of individual ratings, so as to un­
derstand the dimensions covered by them, and only use them as a part
of their credit analysis. These ratings must not be interpreted as “buy”
or “sell” recommendations, since they do not predict the profitability of
investing in the company that is being rated.
Generally, it is expected that the ratings should reflect an opinion
that is based on, at least a three year forward assessment of the financial
health of the obligor, with an annual review. However, this does not
mean that the ratings are a static process. In fact, a rating alert can also
be warranted in the case of an unanticipated change in the macro, or
micro environment of the obligor. In such cases the obligor is placed on
a rating watch, and the impact of the event is assessed over time, which
may result in a continuation of the existing rating, or also a transition.
An example of such an event can be mergers and acquisitions, a change
in the senior management, a change in certain government policies that
can trigger or mitigate the associated business risk, etc. Since the rat­
ings are a function of endogenous, as well as exogenous factors, they are
highly susceptible to change. Any significant modification of the factors
involved, such as economic trends, business cycle change, or any in­
ternal change in the company, can result in a rating revision.
Credit ratings have the potential to be extremely powerful and
useful, despite a host of intricacies associated with their use. Since
ratings are relative in nature, and they help to create an ordinal ranking
of similar obligators, which can be very informative for investors or
lenders. Ratings can also be beneficial for the entity that is being rated.
Companies and the government, which possess ratings above a certain
mark, often have access to direct channels for raising funds. This also
lowers their cost of raising capital. On a larger spectrum, credit ratings
offer a public service by providing access to information, and lowering
the costs that are associated with them. By offering their users a holistic
approach to credit risk assessment of the entity at hand, they enable the
informed decision making authorities such as the investors, lenders, etc.
This increases the transparency in the economy, and directly addresses
the issue of information asymmetry. While information asymmetry
cannot be completely eliminated, credit ratings help substantially to
mitigate this problem.
3. Ratings criteria
The banks’ credit strength emanates from various macroeconomic,
and firm level characteristics (Gogas et al., 2014). Therefore, we have
followed a top down approach in order to construct the variable set that
will be used for the ratings prediction. In this section, we briefly review
these factors and outline their measurement as well.
3.1. Macroeconomic environment
The credit ratings assessment takes into account the systemic dy­
namics that contribute towards the performance of the respective bank
(s). These macroeconomic factors have been instrumental in stabilizing
the financial system and providing a conducive banking environment.
For this research, we have focused on four macroeconomic factors that
contribute towards the banks’ ratings.
3.1.1. Economic strength
The resilience of the banking system emanates from the economic
strength of a country. In this context, the growth prospects, as well as
scale of the economy are equally important (Öǧüt et al., 2012). We
proxy economic strength through different variables, including the GDP
growth rate, volatility in the GDP growth, the GDP Per capita, di­
versification and the volatility of the oil prices. The volatility of the oil
J.-P. Li, et al. Technological Forecasting & Social Change 161 (2020) 120309

prices is particularly important for the GCC economies, as some coun­ Table 1
tries have a high revenue reliance on hydrocarbons (Su et al., 2020c). – Definition of variables used to determine credit ratings.
Financial Inputs
3.1.2. Institutional strength
The bank ratings are dependent on a country's institutional strength Franchise Strength
1. Market Position by Business Lines
that determines the functional conduciveness for the commercial banks.
2. Diversity in Product Mix
The institutional strength is a function of transparency, history of in­ 3. Asset Size
stitutional development, policy effectiveness and the central bank's 4. Ownership Structure
credibility and intervention capacity (Kanagaretnam et al., 2014). In Earnings Power
order to capture the institutional strength of the banks, our model in­ 1. Net Interest Margin = [Net Interest Income + Dividends] / Average Financial
Assets
corporates the World Bank's government effectiveness index, the World
2. Proportion of Non-Interest Income = [Total Operating Income - Net Interest
Bank's rule of law index, the World Bank's control of corruption index, Income] / Total Operating Income
the inflation level, and the inflation volatility. 3. Asset Yields = [Interest Income + Dividends] / Average Financial Assets
4. Cost of Funding = Interest Expense / Interest Bearing Liabilities
5. Cost-income Ratio = Total Operating Expenses / Total Operating Income
3.1.3. Fiscal strength
6. Pre-tax Margin = Income Before Taxes / Average Total Assets
The fiscal strength factor relates to the government's finances, and 7. IBPT/RWAs = Income Before Provisions and Taxes / Average Risk Weighted
the level of public debt. This involves both the level of debt burden, and Assets
the affordability factor, as this impacts the overall stability of the fi­ 8. Cost of Risk = Loan Loss Provisions / Net Lending to Customers
nancial system (Jordà et al., 2016; Su et al., 2020a). To account for the 9. Return on Assets = Net Attributable Income / Average Total Assets
10. Return on Equity = Net Attributable Income / Average Equity Attributable to
fiscal strength, we have included the government's debt to GDP, the
Parent
government's debt to revenues, the interest payment to revenues, and Risk Profile
the interest payment to the GDP, in our predictive models. 1. Impaired Loans ratios (by business segment) = Impaired Loans / Total Gross Loans
2. Net Charge-offs Ratio = Write-offs of Customer Loans (net of recoveries) / Total
3.1.4. Susceptibility to risk Gross Loans
3. Provisions to IBPT = Loan Loss Provisions / Income Before Provisions and Taxes
The susceptibility of exposure to the risk, accounts for a country's 4. NPL coverage = Accumulated Loan Loss Provisions / Impaired Loans
ability to cope with sudden and extreme shocks. This is imperative Funding and Liquidity
because a systemic turbulence can easily spillover to the banking sector, 1. Loan to Deposit Ratio = Net Lending to Customers / Deposits from Customers
resulting in erosion of the credit capacity. The variables we will use for 2. Non-deposit Funding Ratio = 1 - [Deposits from Customers / Total Liabilities
(excluding Equity)]
the susceptibility to risk include, political risk (World Bank's Voice, and
3. Liquidity Coverage Ratio
Accountability index, GDP per capita), the government's liquidity risk 4. Net Stability Funding Ratio
(Gross borrowing requirements, relative to the GDP) and the external Capitalization
vulnerability risk (The current account balance, and the foreign direct 1. Tier 1 Ratio = Common Equity Tier 1 / Risk Weighted Assets
investment inflows to the GDP). 2. Total Capital Ratio = Total Regulatory Capital / Risk Weighted Assets
3. Total Equity to Total Assets Ratio = Equity Attributable to Parent / Total Assets
4. Tangible Total Equity to Tangible Total Assets Ratio = [Equity Attributable to
3.1.5. Credit conditions Parent - Intangible Assets] / [Total Assets - Intangible Assets]
Credit conditions play a critical role in the banking risk factor, as a 5. Basel III Leverage Ratio = Tier 1 capital / Total Leverage Exposure
high leverage or sudden credit expansion can lead to asset quality vo­ Macro Profile
Economic Strength
latility (Popov and Udell, 2012). Therefore, it is important to deliberate
1- GDP Growth Rate
a financial deepening for a valid, and consideration worthy rating as­ 2- Volatility in GDP Growth
sessment. In order to quantify the country level credit conditions, we 3- GDP Per capita
have used a certain level of private sector credit in relation to the GDP 4- Diversification
and growth in the private sector credit to the GDP. 5- Volatility in Oil Prices
Institutional Strength
1. World Bank Government Effectiveness Index
3.1.6. Funding conditions 2. World Bank Rule of Law Index
The funding issues that develop at the sector level can result in 3. World Bank Control of Corruption Index
systemic shocks. These become more problematic in interconnected 4. Inflation Level
5. Inflation Volatility
systems, in which the issues with one bank become contagious for the
Fiscal Strength
others, due to the counterparty exposures. Once there are concerns 1. Debt Burden Govt Debt/GDF)
about one or even a few institutions, this could lead to a loss of con­ 2. Govt Debt/Revenues
fidence in the overall system, resulting in panic and bank runs. 3. Govt Interest Payment/Revenues
Therefore, it is important to assess the overall funding stress, as it can 4. Govt Interest Payment/GDP
Susceptibility to Risk
impact the banks' credit standings (Ritz and Walther, 2015). In order to 1. Political Risk
capture the funding conditions across the GCC, we have used the dif­ 2. Govt Liquidity Risk
ference between the bank borrowing rates and the overnight indexed 3. External Vulnerability Risk
swap, and also the changes in the central bank balance sheets. Credit Conditions
1. Level of Private Sector Credit to GDP
2. Growth in Private Sector Credit to GDP
3.1.7. Industry structure Funding Conditions
The industry structure is an important source of extracting the 1. Market funding measures – diff between bank borrowing rates and overnight
strengths and weaknesses of the participating banks. If there is an indexed swap
oversupply of credit, with limited demand, this could result in weak 2. Changes in Central Bank Balance Sheets
Industry Structure
underwriting, which may lead to higher loan infections. Similarly, if the 1. Industry Concentration
industry is heavily concentrated, the market power will result in com­ 2. Public Sector Ownership of Banks
petitive outreach, for only a few banks (Afzal and Mirza, 2012). The 3. Risk Appetite Liberalization – Use of Off Balance Sheet Vehicles/Total Assets
presence of the public sector ownership is also a possible distortion to
the competition structure. Lastly, the financial intermediation is sensi­
tive to the liberalization and innovation, and this will have an impact

3
J.-P. Li, et al.
on the individual banks’ performance as well. Thus, we have in­
corporated the industry structure in our ratings prediction model, by
using the Herfindahl index, the public sector ownership of the banks
and the risk appetite, that is measured as a proportion of the off balance
sheet exposure, to the total assets.
3.2. Bank specific factors
The credit ratings are a function of many bank specific factors.
For this purpose, we have briefly introduced these factors below.
The complete list that is needed to quantify these factors, for our pre­
dictive models, is reported in Table 1.
3.2.1. Franchise strength
The banks’ franchise is vital for the risk assessment and the ability to
withstand credit shocks. The franchise strength emanates from a bank's
market position, geographic outreach, depth of the product portfolio
and the ability to cope with the changing regulatory, and operating
environment. Although, the size of the bank, on a standalone basis, may
not result in a specific rating, it may, however, indicate the probable
scale of the benefits that can be availed. Lastly, the ownership structure
could possibly also point towards the operational strategies and the
governance. Also, the banks with better franchise strength have a
competitive penetration in the deposit and the lending markets
(Pasiouras et al., 2007).
3.2.2. Earnings power
A bank's earning is also a critical factor that needs to be considered,
as this helps in absorbing the credit losses and the asset depletion, and
ultimately avoids capital erosion as well. The banks with an aggressive
underwriting profile, and a riskier client profile, require a strong
earnings power, in order to support the interest margins and the re­
levant provisions (Mirza et al., 2015). The earnings ability, and its
sustainability are vital, so as to gauge a bank's capacity to respond to
recessions and high volatility.
3.2.3. Risk profile
Risk taking is an essential characteristic of financial intermediation.
Therefore, it is important to assess a bank's risk profile, and the miti­
gation strategies that put are in place. The risk profile broadly emanates
from retail, wholesale credit, capital markets and the operational risk.
The commercial banks mostly have lending as their core business tool,
and hence, a major concentration of the risk revolves around different
types of lending activities (Afzal and Mirza, 2012). A balanced risk
profile is imperative, in order to have a robust risk absorption capacity,
especially during periods of economic stress.
3.2.4. Funding and liquidity
The funding and liquidity analysis looks into the funding mix of a
bank, along with its alignment with the asset deployment. This is par­
ticularly important in order to ensure that the bank is able to meet its
liabilities, in case of unanticipated withdrawals or deposit rollovers.
Banking institutions that finance their assets from retail deposits have a
better stability, and a strong ability to cope with a possible liquidity
crunch (Öǧüt et al., 2012). In case if there are any high capital market
activities, the financing should ideally be undertaken from wholesale
funding. The propositions of Basel III have also stressed on adapting
measures that takes into account both the available and the required
liquidity options.
3.2.5. Capitalization
It is noteworthy that a bank's capital acts as a risk absorption
cushion to safeguard the unsecured liabilities. This enables the bank to
sustain losses, and ensures continuity in the operations as well
(Jiménez et al., 2017). An adequate amount of capital is essential for
keeping the investors’ and the counterparties’ confidence in place. The
4
Technological Forecasting & Social Change 161 (2020) 120309
financiers’ confidence, and the continuity in operations helps in the
balance sheet growth, via strategic investment decisions. The capital
capacity is also vital for dividends and buyback decisions, and some­
times also determines the sponsors’ and the regulators’ ability to em­
ploy capital injection during a national or global financial crisis.
4. Machine learning models
The machine learning models have considerable precision, due to
their data mining ability, limited reliance on assumptions, automation
and the capacity to improve overtime. In this section, we have pre­
sented the five machine learning models that are used in this study.
4.1. Artificial neural network (ANN)
Artificial Neural Networks (ANN) are useful in computing a target
variable from various independent factors. Their ability to predict
credit risk metrics has been previously documented by (Angelini et al.,
2008) and (Bahrammirzaee, 2010). These networks consist of an input
layer, many hidden layers in between, and an output layer. Ad­
ditionally, the nodes are interconnected across these layers. The input
node will take a weighted sum of independent variables in the model,
and through a nonlinear activation function, they will pass the output
to the next layer. The process will continue across the hidden layers, till
it reaches the final output. Typically, the neural network will enable the
machine learning of the weights, as they pass from the input layer to the
hidden layer and finally towards the final output. An important aspect
of the ANN is the presence of weight decay, which ensures that the
hidden layer is eliminated, as soon as its relevance fades away, or there
is an update (Tkáč and Verner, 2016). The equation for a node, with a
weighted sum of inputs is represented as below:
N
= f ( b + x . ) = f (b + xi i)
i=1
x 1×n, n × 1, b d1× 1, z d1 × 1
where b represents a bias in each node, and has a value of 1, and n is the
number of model inputs.
The training of the model starts off by randomly allocating the
weights to all the inputs for each node, followed by a forward pass that
is used to calculate the output of each of the nodes, and ultimately the
final target. The final output is then compared with the actual value, in
order to measure the error. This error is then back propagated, and the
contribution of each node's weight is estimated and adjusted, through
the gradient descent. In the next pass, these adjusted weights are then
taken forward to calculate the new output. This process continues till
the error converges to our training tolerance of 0.001. Through this
process, we found our best fit to be an ANN with 3 hidden layers, and a
weight decay of 0.1.
4.2. Support vector machine (SVM)
A support vector machine can be used as a predictive model, that is
based on using certain classifications (Guenther and Schonlau, 2016).
Moreover, on the training sample, it fits a boundary to a distribution of
similar points, belonging to a class. This training sample is then used to
compare whether the points from test sample are inside the boundary or
not. Once a boundary is established the training data is redundant
leaving core points to be relevant. These core points are termed as the
support vectors. The advantage of the SVM is that it can be used for
both linearly separable, and inseparable data (Tiwari, 2017). For the
former, it establishes a boundary that segregates the data with a max­
imum margin. For the latter, it transforms the data x from the input
space, to a high dimension space H, such that x ∈ MI → φ(x) ∈ MH, with
a kernel functionΦ(x), to establish the separating boundary. For our
specific analysis, the SVM takes a multiclass approach, where each class
J.-P. Li, et al.
is separated from others, and the model is trained to distinguish the
instances across classes (Zhu and Hastie, 2005). In the test phase, the
class A, with pattern B, is determined by;
A=
0, {
n, dn (B ) + tl > 0
if
dn (B ) + tl 0
with, dn (B ) = max{di (B )}iN=l 1 where di (B)
is the distance between B and the SVM boundary of class i, and tl is the
origin of the classification.
4.3. Random forests (RF)
The random forests have been widely used in the forecasting cred­
itworthiness of the counterparty (Tang et al., 2019),
(Malekipirbazari and Aksakalli, 2015), (Barboza et al., 2017). This
prediction technique is based on the wisdom of the crowd. The Random
forest comprises of many individual decision trees that work as an
ensemble. The individual tree in the forest leads to a class prediction,
and the most robust class eventually becomes the model output. The
basic idea is that, the individual models that have low correlations with
each other, come together to produce ensemble predictions. In this way,
the trees that are a part of the ensemble will protect each other from
individual noise. Even if there is an error in a few trees, the accuracy of
the others could lead to a collective output that is significantly precise.
To ensure that there is low correlation between the individual trees, the
two underlying processes are quite helpful. The first one is the bagging,
through which each tree is allowed to create a random sample with a
replacement from the dataset. The trees are then trained, using this
randomly populated sample. The second process is referred to as the
feature randomness. In this, while splitting the nodes, all the possible
variables are considered, and the one that produces the maximum se­
paration between the observations is selected. The model is trained in a
way that the independent variables are also randomized, and each tree
can select only from a unique set that is not likely to repeat itself.
4.4. Chi-squared automatic interaction detector (CHAID)
The CHAID is a statistical tool proposed by (Kass, 1980), that can
help predict a target variable from a set of predictive variables. The
predictive tree allows the independent variables to merge, and lead to
an optimal outcome of the dependent variable, called the root
(Cha et al., 2017). The technique can employ nominal, ordinal and
continuous data, and divide them into categories as well. These cate­
gories are referred to as parent nodes, which will be cross tabulated into
further categories that are called child nodes. This process continues
until the best prediction is achieved (Chen, 2016). The target variable,
in this case, is the rating, while the predictive variables are the various
rating criteria that will be split and cross tabulated, till an optimal
rating is ultimately predicted. Since our dependent variable is catego­
rical, we use the Chi square for the measurement. This is calculated for
both the actual and the expected values, with the p value being a
function of the calculated statistics. The Pearson chi square is estimated
as,
I J
(bij kij ) 2
X2 =
i=1 j=1 kij
where bij is the actual, and kij is the expected cell frequency.
4.5. Classification and regression trees (CART)
The CART is a technique that predicts the dependent variables using
various, labeled independent variables (Krzywinski and Altman, 2017).
This employs the classification trees for a categorical target variable, or
the regression trees, if the predicted estimate is continuous in nature.
There are two main advantages of the CART models. No assumption is
made about the dataset, and also, these work well with the nonlinear
observations. Moreover, the standardization of the data is not needed,
5
Technological Forecasting & Social Change 161 (2020) 120309
and the outcome is predicted using an “if-else” algorithm. There are
three steps that are involved in the CART. It starts off by constructing a
maximum tree, followed by optimizing the size of the tree, and then
concluding by data classification in the constructed tree. The classifiers
will repeat till a stopping criteria is achieved, which in this case, will be
a final rating. Each round of this iteration is called a node, and nodes
fall into three main types. 1). A root node, that does not have a parent
(originator) but further leads to two sub nodes (children), 2). An in­
ternal node, that has an originator (parent), and leads to two sub nodes
(children) and finally 3). And finally, a leaf node, that has an originator
(parent), but no children nodes.
5. Data and methodology
Our data comprises of the rated commercial banks, across six GCC
countries. Most of the banks in the GCC region are rated by Standard
and Poor's, Moody's, Fitch and the Capital Intelligence. Our analysis is
based on the publicly disseminated long term entity ratings that come
from these organizations. For the purpose of this study, we have con­
sidered a sample period between January 2010 and December 2018,
and the quarterly data is extracted for the variables that are discussed in
Section 2. This period is then further divided into a training period, and
an out of sample prediction period (2016 – 2018). Based on this, we
extracted a final sample of 80 banks from the GCC that have been rated
throughout this period, and the required data is then made available.
The country wise sample breakdown is reported in Table 2.
We have assigned numerical values from 17 (for highest credit
quality) to 1 (lowest credit quality and default). Moreover, in order to
homogenize the rating scales across the rating agencies and the cate­
gories of the notations, we have classified them as R1, R2, R3 and up to
a value of R7. This classification is based on the rating definitions that
are publicly available on the website of the four rating agencies. The
rating classifications, and the categorization for the four ratings agen­
cies are available in Table 3.
We have also adopted the following procedure, so as to employ
various machine learning algorithms, for the prediction of the credit
ratings.
1) The historical data that pertains to the variables for the complete
period is collected and organized, as per the different ratings that
are categorized.
2) The algorithms for the five different classification techniques are
applied to train the data.
3) The best algorithmic specification is extracted from the trained data.
This will follow an iterative process till a target precision is
achieved, so as to finalize the predictive model.
4) The best predictive model from each category is used to obtain the
output i.e. final target credit ratings.
5) This output is then compared with assigned ratings, in order to es­
timate the accuracy of the predictions.
The process is summarized in Figure 1
In order to measure the prediction accuracy of these models, we
have used the F1- score, specificity, and the accuracy. The predictive
instances are classified as,
Table 2
No of sample banks from GCC.
KSA 18
Qatar 15
Kuwait 12
UAE 13
Oman 10
Bahrain 12
Total 80
J.-P. Li, et al. Technological Forecasting & Social Change 161 (2020) 120309

Table 3
Rating Scales and Categorization (Cat) and Classes.
S&P Moody's Fitch Capital Intelligence Cat Classes

Highest Quality Investment Grade AAA Aaa AAA AAA 17 R1

High Quality AA+ Aa1 AA+ AA+ 16 R2
AA Aa2 AA AA 15
AA- Aa3 AA- AA- 14
Strong Payment Capacity A+ A1 A+ A+ 13 R3
A A2 A A 12
A- A3 A- A- 11
Adequate Payment Capacity BBB+ Baa1 BBB+ BBB+ 10 R4
BBB Baa2 BBB BBB 9
BBB- Baa3 BBB- BBB- 8
Likely to Settle Obligations Speculative Grade BB+ Ba1 BB+ BB+ 7 R5
BB Ba2 BB BB 6
BB- Ba3 BB- BB- 5
High Credit Risk B+ B1 B+ B+ 4 R6
B B2 B B 3
B- B3 B- B- 2
Very High Credit Risk CCC+ Caa1 CCC+ C+ 1 R7
CCC Caa2 CCC C
CCC- Caa3 CCC-
Near Default CC Ca CC C-
C
Default Default SD C DDD D
D DD
D

Fig. 1. The Flow chart of the Machine Learning Forecast Process.

Table 4 True Positive (TP): High credit quality, predicted as higher ratings.
Selected Descriptive Statistics . False Negative (FN): High credit quality, predicted as lower ratings.
Bahrain KSA Qatar Kuwait UAE Oman
True Negative (TN): Low credit quality, predicted as lower ratings.
False Positive (FP): Lower credit quality, predicted as higher ratings.
Franchise Strength A brief description of these tools is presented below.
Asset Size (USD Bln) 554,71 700,15 430,15 229,16 804,19 79,67
Earnings Power
Net Interest Margin 2,70% 3,40% 2,50% 3% 3,20% 2,90%
F1 Score
Yield on Credit 4,30% 4,80% 3,80% 4,20% 4% 3,30% This score is a measure of the accuracy of the model forecast. It is
Cost of Funding 3,30% 1,00% 2,80% 2,10% 2,00% 2,40% calculated as;
Return on Equity 9,5% 14,1% 15,0% 8,7% 12,7% 11,7%
Risk Profile precision × recall
Impaired Loans 5718% 1382% 5594% 5117% 6072% 2123% F1 = 2 ×
precision + recall
ratios
NPL coverage 46,10% 152% 101,50% 102% 65,60% 57,70%
Funding and where the precisions refer to the proportion of positive predictions, to
Liquidity the total number of positive class values that are predicted [TP/ (TP
Loan to Deposit 94,2% 135,3% 75,6% 98,4% 93,1% 126,8% +FP)]. A recall is the proportion of positive predictions to the total of
Ratio
Liquidity Coverage 183% 192% 190% 160% 290% 320%
the true positives and the false negatives [TP/ (TP+FN), and may also
Ratio be referred as sensitivity. A higher F1 score represents a higher pre­
Capitalization dictability of the model.
Total Capital Ratio 17,6% 18,5% 17,6% 18,0% 18,9% 15,9% Specificity
Tier 1 Capital to 16,10% 17,60% 15,10% 16,70% 17,20% 14,10%
The specificity is the proportion of observed negative instances, to
RWA
the total negative predictions. This is calculated as;

6
J.-P. Li, et al. Technological Forecasting & Social Change 161 (2020) 120309

Fig. 2. Credit Ratings Variables Ranking - Artificial Neural Network (ANN). (For interpretation of the references to colour in this figure legend, the reader is referred
to the web version of this article.)

TN TP + TN
S= Acc =
TN + FN TP + TN + FP + FN

Accuracy
6. Results and discussion
The accuracy is a measure of accurate predictions. This estimate
reflects if the model was able to capture true positives and true nega­
The country wise value weighted descriptive statistics, of the se­
tives, and represent them as a percentage of the total predictions. For
lected factors for the GCC, are presented in Table 4. The banking sectors
our dataset, this will represent the ability of the model to predict a high
in UAE and KSA dominate the market, with an average asset size of
rating for high credit quality, and a low rating for low credit quality.
$804Bln and $700Bln, respectively. While Oman is the smallest in size,

7
J.-P. Li, et al.
Fig. 3. Credit Ratings Variables Ranking - Support Vector Machine (SVM). (For interpretation of the references to colour in this figure legend, the reader is referred to
the web version of this article.)
with $79.6Bln in banking assets. The Net interest margin (NIM) is more
or less similar across the region, with a maximum of 3.4% for KSA, and
a minimum of 2.5% for Qatar. Additionally, The NIM for KSA is a
function of a significant credit yield (4.8%), and a very low cost of funds
(1.0%), which has enabled the banking sector to secure a dominant
position among its regional peers. Other than this, the average impaired
loan ratio is on the higher side for UAE (6%), Bahrain (5.7%) and Qatar
(5.5%), but is low for KSA (1.3%) and Oman (2.1%), representing their
better asset quality. Plus, the coverages across the region are adequate,
with KSA having the maximum at 1.52x. Moreover, the capitalization is
8
Technological Forecasting & Social Change 161 (2020) 120309
sufficient as well, with the CAR ranging from 15.9% to 18.9%.
We present the ranking of our independent variables in Figures 2, 3,
4,5, and 6 for the five modelling techniques that have been taken into
consideration. In order to offer a meaningful explanation of the re­
levance of our variables, we have consolidated these as per the different
rating criteria, and observe their importance for each rating scale. We
have also observed that, for the highest credit quality entities (R1), the
macroeconomic factors of economic, institutional and fiscal strengths
were the most important. Given the governance structure of these
economies, this is plausible from the GCC perspective, where the
J.-P. Li, et al.
Fig. 4. Credit Ratings Variables Ranking – Random Forests Ensemble. (For interpretation of the references to colour in this figure legend, the reader is referred to the
web version of this article.)
institutions are dependent on the structural strengths of the macro­
economic factors (Saberi and Hamdan, 2019). Similarly, the con­
centrated industry structure offers a competitive advantage to larger
banks, and is deemed important for the credit quality (Haskour et al.,
2011). In addition, among the bank specific factors, the franchise
strength and the earnings power have higher relevance for the banking
performance. This is in line with the findings of (De Jonghe and
Vennet, 2008), who reported similar observations for the European
banks.
9
Technological Forecasting & Social Change 161 (2020) 120309
The importance of these macro factors remains consistent across
most of the investment grade ratings (R2, R3 and R4). However, as we
move closer to the speculative grade, and the low credit quality entities,
the bank specific factors become more relevant for ratings. Our pre­
dictive models suggest that the prime determinants of lower ratings are
capitalization, funding, liquidity and the risk profile. This is under­
standable because even if the economic fundamentals are adequate, a
problem with these factors could result in lower ratings for the banks.
As suggested by (Laeven et al., 2016), bank capitalization is vital in
J.-P. Li, et al.
Fig. 5. Credit Ratings Variables Ranking – Random Chi-squared Automatic Interaction Detector. (For interpretation of the references to colour in this figure legend,
the reader is referred to the web version of this article.)
order to withstand aby systemic shocks, and this makes it extremely
important for the lower credit quality (R7). The overall credit and
funding conditions are also critical for this group, as the credit crunch
and funding constraints add extra pressure on an already stressed re­
payment capacity.
The results for the models’ predictions are presented in Table 5. This
table is based on the consolidated output for all the ratings. The random
forests demonstrate the highest predictability, with a maximum F1
score, specificity, and accuracy. Similar to (Kwakkel and
10
Technological Forecasting & Social Change 161 (2020) 120309
Cunningham, 2016), we also believe that the superiority of this ap­
proach stems from the bagging and randomness that is underlying the
algorithm of the ensemble random forests. These findings are compar­
able to (Tang et al., 2019), who observed random forests to be a useful
measure for the counterparty risk in the credit cards that are used in
China's energy industry. In the same stride, the artificial neural net­
works’ precision is ranked second, followed by the support vector ma­
chine, CHAID and CART.
In order to ascertain the robustness of the random forests algorithm,
J.-P. Li, et al. Technological Forecasting & Social Change 161 (2020) 120309

Fig. 6. Credit Ratings Variables Ranking – Classification and Regression Trees. (For interpretation of the references to colour in this figure legend, the reader is
referred to the web version of this article.)

Table 5 we generate the rating predictions for the individual rating scale (R1 to
Comparison of Model Accuracy - All Ratings. R7). The precision remains consistent for the investment grade, spec­
Model Rank F1 Score Specificity Accuracy
ulative grade and the default ratings. Therefore, with the insensitivity
towards multicollinearity, the optimization of the non-linearity and the
Artificial Neural Network (ANN) 2 0,78 0,82 0,80 flexibility of choice of the functional form, makes random forests a
Support Vector Machine (SVM) 3 0,65 0,74 0,71 superior predictor of the credit quality. The results for this are reported
Random Forest (RF) 1 0,85 0,90 0,93
Chi-squared Automatic Interaction 4 0,51 0,61 0,46
in Table 6 (Panel A, B and C). The interesting observation here is the
Detector (CHAID) performance of the Artificial Neural Networks that were ranked at
Classification and Regression Trees 5 0,31 0,41 0,40 number 3 for the investment grade ratings, but their precision was
(CART) ranked at number 5, for the speculative (Panel B) and default ratings

11
J.-P. Li, et al. Technological Forecasting & Social Change 161 (2020) 120309

Table 6 predictions were done for different rating classes. However, we did
Comparison of Model Accuracy across Ratings Classes. observe that for the speculative and default predictions, the precision
Panel A R1 to R4 Investment Grade Ratings for the CART experienced significant improvement. Therefore, for stress
Model Rank F1 Score Specificity Accuracy predictions, the CART algorithms can be used, along with the random
forests ensembles, for the optimal predictions. It is noteworthy that
Artificial Neural Network (ANN) 3 0,70 0,72 0,69
these findings have important inferences for the banks and the relevant
Support Vector Machine (SVM) 4 0,67 0,69 0,65
Random Forest (RF) 1 0,81 0,79 0,75
stakeholders, as the ratings are not only associated with credit assess­
Chi-squared Automatic Interaction 2 0,75 0,76 0,73 ments, but also have implications for stock liquidity, IPO pricing, cor­
Detector (CHAID) porate governance, capital structure choices etc.
Classification and Regression Trees 5 0,51 0,58 0,53
(CART)
CRediT authorship contribution statement
Panel B R5 and R6 Speculative Grade Ratings
Model Rank F1 Score Specificity Accuracy Jing-Ping Li: Conceptualization, Data curation, Formal analysis,
Project administration, Supervision. Nawazish Mirza: Methodology,
Artificial Neural Network (ANN) 5 0,41 0,39 0,42 Software, Formal analysis. Birjees Rahat: Visualization, Investigation,
Support Vector Machine (SVM) 3 0,79 0,81 0,77
Writing - review & editing. Deping Xiong: Conceptualization,
Random Forest (RF) 1 0,89 0,90 0,87
Chi-squared Automatic Interaction 4 0,62 0,65 0,70 Validation, Project administration, Supervision, Writing - original draft.
Detector (CHAID)
Classification and Regression Trees 2 0,85 0,88 0,84 Acknowledgments
(CART)

Panel C R7 Default Ratings
Model Rank F1 Score Specificity
Artificial Neural Network (ANN) 5 0,30 0,28
Support Vector Machine (SVM) 4 0,60 0,56
Random Forest (RF) 1 0,85 0,87
Chi-squared Automatic Interaction 3 0,79 0,76
Detector (CHAID)
Classification and Regression Trees 2 0,83 0,85
(CART)
(Panel C). Thus, we attribute this to the large forecast error that ema­
nates from the loss of clustering, and the higher correlation within the
firm specific variables, during periods of credit stress. Therefore, we
propose that, in order to assess the credit risk for the firms with lower
asset quality, the CART can be used as an additional specification, along
with the random forests. The difference between the F1 score, specifi­
city and the accuracy of the random forests, and the CART is not highly
significant for the lowest ratings scale.
7. Conclusion
The technological developments over the years have resulted in
many financial innovations. Machine learning is one such development
that has revolutionized financial decision making in the recent times.
The superiority of the machine learning models stems from their ability
to learn from the data set, and then not rely on any exogenous as­
sumptions. Therefore, it is not a surprise that the application of the
machine learning algorithms has now been adapted for many financial
applications. In this paper, we have attempted to predict credit ratings
by using a multitude of machine learning models, and establish their
precision for the given forecasts.
For this purpose, we used various macro and firm level factors to
train the model, and then used out of sample predictions, for the years
spanning from 2016 to 2018. In terms of the variable importance, our
findings have suggested that for the investment grade ratings, the
macroeconomic factors were more relevant. However, for the spec­
ulative grade ratings, the importance of the firm level factors was a
prominent factor that was taken into consideration. Within the spec­
ulative grade, as ratings edge towards the default mode, the capitali­
zation became much more relevant. Hence, this was a logical ob­
servation, as when the firms are closer to default, new capital injection
becomes difficult and the quality of the existing capital becomes cri­
tical.
Moreover, the prediction precision was at its maximum for the
random forests, for all the rating classes across the three different
measures that we employed. This also remained consistent when the
This work is supported by the “Fund Program for the Scientific
Accuracy Activities of Selected Returned Overseas Professionals in Shanxi
Province” since the year 2017 (Grant No. 2017–1389), and the
0,34
0,52
“Research Project Supported by Shanxi Scholarship Council of China”
0,91 since the year 2017 (Grant No. 2017–100).
0,81
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Jing-Ping Li Jing-Ping Li is a Professor and Vice Dean of School of Finance, Shanxi
University of Finance and Economics, Taiyuan, China. Li's research and teaching includes
Derivatives and Risk Management, Corporate Finance and Budgeting, Security Valuation
and Investments as well as investment portfolio, risk management. He has 10 years in­
dustry experience in financial consultancy.
Nawazish Mirza Nawazish Mirza is an Associate Professor of Finance at La Rochelle
Business School – Excelia Group, France. His-research interests include financial tech­
nology, credit ratings, risk management, financial intermediation and valuations. He has
extensive professional and consulting experience in credit ratings, investment banking
and valuation of new technologies.
Birjees Rahat Birjees Rahat is an Adjunct Faculty of Finance at La Rochelle Business
School – Excelia Group, France. Her research interests include risk management, credit
ratings, socially responsible investments, sustainability and environmental finance. She
has professional experience in credit ratings and portfolio risk management.
Deping Xiong Deping Xiong is a Full Professor and Dean of School of Finance, Yunnan
University of Finance and Economics, Kunming, Yunnan, China. His-research interests
include innovation in high-tech industries, financial markets, and environmental
finance. Her interdisciplinary work was published in journals such as including,
Resources Policy, Economic Research-Ekonomska Istraživanja, Journal of Intelligent and
Fuzzy Systems and others.