MACHINE LEARNING CREDIT SCORING MODEL FOR MICROFINANCE

INSTITUTIONS IN KENYA

1.0 INTRODUCTION

1.1 BACKGROUND

Microfinance institutions (MFIs) have been key players in financial inclusion for many
underserved populations who need financial services. By offering micro-loans, insurance
products, and savings, MFIs have empowered low-income individuals, improved their economic
conditions, fostered entrepreneurship and poverty reduction. However, a significant barrier to the
growth and sustainability of MFIs is the assessment of the creditworthiness of clients who mostly
need more credit histories (Laila, Nur & Alias, Laila. (2024). MFIs use credit scoring techniques,
which evaluate and present the likelihood that a client will default on the loan, making it easier to
manage credit risk. This has rested the burden of traditional credit scoring models, which heavily
rely on historical financial data, which is usually unavailable or inadequate. Thus, there is a need
for more innovative credit assessment approaches. Assairh, L., Kaicer, M., & Jerry, M. (2021)
With finance institutions welcoming the advent of machine learning, it has offered a promising
solution to this challenge. Machine learning technology helps predict patterns, accurately predict
outcomes, and simultaneously analyze vast amounts of structured and unstructured data.
Machine Learning provides a wide-ranging result of creditworthiness’ by leveraging alternative
data sources like the use of mobile phones, activities in social media, and transactional
behaviors. OECD (2021)

1.2 credit scoring and its importance

Ali, Amjad & Rafi, Muhammad (2014) defines credit scoring as a fair technique that assists
lenders in deciding whether to grant or reject credit to their borrowers. They also point out that
credit scores are the product of an advanced analytical model that translates borrowers' credit
history into a numerical value, reflecting the level of risk associated with each specific customer
in a fair and unbiased manner. Credit scoring consists of techniques and modes that help
microfinance institutions lend credit to their borrowers. These models provide detailed
information on who to insure with credit, how much credit will be insured, and how to improve
customers' credit viability (Tselekidou, 2023). Tselekidou further observes that credit scoring
models measure the creditworthiness of borrowers, which physical characteristics like height,
weight, or money will not define.

Credit scoring is critical in managing risks and ensuring profit maximization in financial
institutions. Within microfinance institutions MFIs, credit scoring solves the challenges of
financial inclusion, operational effectiveness, credit risk management, and economic growth.

According to Khursheed (2022) Microfinance aims to provide financial services to marginalized

and underserved populations. In developing areas, many financial borrowers lack formal credit
histories, making obtaining access to loans challenging. The use of credit scoring models, and
especially those using alternative non-traditional data sources like mobile phone usage,
transactional behaviors, and social media activities, can evaluate the creditworthiness of these
borrowers

a) facilitating financial inclusion Credit scoring techniques enable MFIs to spread to a broader
population range, including those without proper credit histories. Financial inclusion plays a
critical role in ensuring that borrowers from deprived populations can access more valuable
services. Ali, Yasser (2023). Lal, 2017 and Ozili, 2018 observe that financial inclusion helps
form a sound financial credit scoring system that fosters economic growth. According to the
World Bank Group (2020), financial inclusion and providing credit to individuals encourage
them to start new businesses or expand existing ones, thus improving their living conditions and
encouraging them to invest in good health and education.

b) Enhancing Risk Management

Numerous risks are associated with lending, and credit scoring is dynamic enough to assess these
risks. For a microfinance institution to maintain its financial health, accurate credit scores help
them determine borrowers' likelihood of repaying or defaulting the loan. Gool et al. (2012). MFIs
use credit scores to ensure sustainable operations by providing services that provide financial
stability to customers. They are also able to tailor their lending practices by reviewing each
customer's profile and monitoring low—and high-risk customers.
c) Improving Operational Efficiency

Credit scores improve the operational efficiency of MFIs. Credit scoring models have solved the
traditional interview assessment, including interviews and community-based evaluations. These
traditional methods were labor-intensive and consumed a lot of time compared to the new
model’s special machine learning, which is automatic and streamlines the processes. They have
reduced the cost of operations and are more scalable since they can handle large volumes of loan
applications in real-time. They have also increased the speed of loan applications, profiting both
the MFI and the customer. (Roy, and Shaw, 2023)

d) Driving Economic Development

There is economic growth when entrepreneurs, farmers, and women at learn can access credit
easily from MFIs. Small businesses grow, creating jobs, generating income, and impacting the
overall growth of the Kenyan economy. (Overes,& Wel,., 2023) When small businesses start
expanding with the existing ones, they foster innovation. These businesses create job
opportunities to the job less while the MFIs are still creating job opportunities (Gambacorta et
al.,2024)

Problem statement

Credit has been a critical indicator to banks and other lending institutions for many years when
lending money to their clients. (Thomas et al. 2017). A borrower's creditworthiness has always
reached after reflection of numerous elements. Using credit scoring mechanisms has enabled a
better estimation of the probability of default and, simultaneously, predict the borrower's
payment performance. (Nyarko Nde et al. 2021). The current literature has concentrated more
on addressing the success of reducing the default payment of the client. For example, Jarrow and
Protter (2019) and Demirgüç-Kunt et al. (2020) A machine learning model for micro-credit
assessment in Peruvian microfinance institutions that was developed by Condori et al. (2021)
using Artificial Neural Networks gave an accuracy of 93.27%. AdaBoost was also used to create
a machine learning model for exceptional issue interplay between finance and actuarial
mathematics in 2021 by Apostolos al, el which used a robust dataset featuring real-life data and
recorded an accuracy of 81.2071%. Bardina et al. (2020) developed a machine learning model
that used alternative data to reveal creditworthiness using social network analysis and a support
vector model that featured 92.19%. In their research, Noriega et al. (2023) recorded some of the
challenges in these machine learning models: representativeness of reality, unbalanced data, and
inconsistency in information reading, among others. It is thus clear that there is still no model
that has assured complete accuracy in credit scoring issues a percentage of risk and uncertainty
to both the borrower and the MFIs. This paper proposes a machine learning model to provide
further accuracy using alternative data.

1.3 Main objective

The study aims to develop a more accurate, dependable credit scoring model that will give
microfinance institutions exact reference scores when evaluating credit risk to their borrowers.

Specific objectives

These research objectives will guide the study

I) To identify the critical variables that affect an individual’s credit score.

ii) To create a machine learning model for predicting an individual’s credit score.

iii)To assess and validate the developed model’s ability to predict an individual’s credit score.

1.4 Research Questions

The research aims to answer the following questions to meet the study objectives:
1. Which variables have a significant impact on an individual’s credit score?
2. How efficient is the model at modeling an individual’s credit score?
3. How accurate is the developed model in predicting an individual’s credit score?

1.5 Significance of the study

In this research, the model will significantly enhance credit risk performance among the
borrowers in MFIs. The study provides a credit scoring model that clearly outlines who to issue
credit to and who to not. The finding of this study will add to the existing literature, making it
possible for financial inclusion for all borrowers with or without a credit history. This model will
reduce loan default since there will be an accurate assessment of the risk to borrowers and
enhance the processing speed of the loan application. This model will also improve technology
in the finance field. While microfinance Institutions in Kenya are expanding quickly, they
operate within the legal framework required. A more considerable significance is the confidence
built within investors and the social development within the societies. This study of credit
scoring in MFIs in Kenya will have far more implications for the MFIs' sustainability, the
borrowers' existence and will, and the overall growth in the finance sector.

This study will also serve as a starting point for other studies in the same area of credit scoring,
addressing both the issues addressed and those not addressed.

1.6 Motivation

In Kenya and the microfinance market, there has been a decry in elevated non-performing loans
(NPLs) and a decline in deposits and memberships. According to the central bank report (2023),
the rise in interest rates, taxation, and other levies, and increased exchange rates remain under
pressure, and the cost of living remaining high has negatively impacted both the savings and
loans for MFIs. In 2023, only four microfinance Banks recorded profits, with the remaining ten
recording losses ranging from KES 8 million to KES 522 million. The statistics are alarming,
and they necessitate a model that will minimize the loan default rate, maximize the granted
loans, and improve institutions' profits

1.7 Scope of the study

This study will focus on developing a machine learning model to predict credit scoring for
microfinance institutions in Kenya. The study employs a comprehensive approach that integrates
various academic, personal, and contextual factors identified as influencers of credit scoring.
Data will be collected from Microfinance institutions in Kenya. The data collection period will
encompass the most recent academic years. The researcher will evaluate the developed machine
learning model for accuracy within credit scoring standards in the finance sector. Ultimately, the
study will develop a reliable credit scoring model that will give institutions a precise reference
score on which to rely for credit scoring assessment.
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