Optimizing the reliability of a bank with Logistic Regression and Particle Swarm Optimization

Abstract: It is well-known that disciplines such as mechanical engineering, electrical engineering, civil engineering, aerospace engineering, chemical engineering and software engineering witnessed successful applications of reliability engineering concepts. However, the concept of reliability in its strict sense is missing in financial services. Therefore, in order to fill this gap, in a first-of-its-kind-study, we define the reliability of a bank/firm in terms of the financial ratios connoting the financial health of the bank to withstand the likelihood of insolvency or bankruptcy. For the purpose of estimating the reliability of a bank, we invoke a statistical and machine learning algorithm namely, logistic regression (LR). Once, the parameters are estimated in the 1st stage, we fix them and treat the financial ratios as decision variables. Thus, in the 1st stage, we accomplish the hitherto unknown way of estimating the reliability of a bank. Subsequently, in the 2nd stage, in order to maximize the reliability of the bank, we formulate an unconstrained optimization problem in a single-objective environment and solve it using the well-known particle swarm optimization (PSO) algorithm. Thus, in essence, these two stages correspond to predictive and prescriptive analytics respectively. The proposed 2-stage strategy of using them in tandem is beneficial to the decision-makers within a bank who can try to achieve the optimal or near-optimal values of the financial ratios in order to maximize the reliability which is tantamount to safeguarding their bank against solvency or bankruptcy.