Proceedings of the 6th International Conference on Computing and Data Science

DOI: 10.54254/2755-2721/87/20241541

Integrating a machine learning-driven fraud detection system

based on a risk management framework

Lingfeng Guo1,6, Runze Song2, Jiang Wu3, Zeqiu Xu4, Fanyi Zhao5
1
Business Analytics, Trine University, AZ, USA
2
Information System & Technology Data Analytics, California State University, CA,
USA
3
Computer Science, University of Southern California, Los Angeles, CA, USA
4
Information Networking, Carnegie Mellon University, PA, USA
5
Computer Science, Stevens Institute of Technology, NJ, USA

6
glf9871@gmail.com

Abstract. This article explores the application of machine learning techniques, specifically
focusing on ensemble methods like Random Forests, for detecting fraudulent activities in digital
financial transactions. Highlighting the evolution from traditional statistical approaches to
modern machine learning models, it underscores the effectiveness of Random Forests in handling
the inherent challenges of imbalanced datasets typical in fraud detection scenarios. Using a
Kaggle dataset of credit card transactions, the study optimizes Random Forest parameters
through rigorous parameter tuning, achieving significant improvements in model performance
metrics such as Area Under the Curve (AUC). The findings underscore the critical role of
machine learning in enhancing fraud detection capabilities, emphasizing the ongoing evolution
and future potential of these methodologies in financial risk management.

Keywords: Fraud Detection, Machine Learning, Random Forest, Financial Risk Management

1. Introduction
The risk management system is a broad and complex topic involving a body of knowledge covering
many aspects. Its construction process is not uniform but according to different business structures for
"targeted" shape from the perspective of industry division, standard credit card industry, cash loan
industry, third-party payment/transaction industry, auto finance industry, and financial leasing industry.
From the perspective of the division of the end audience, it can be divided into B end (to B) and C end
(to C). With the continuous improvement of national policy supervision, especially in the financial
industry, the importance of risk compliance has increased sharply.[1]Therefore, the construction of the
risk management sub-system can be divided into risk prevention and control and risk compliance.
The division from different angles is to focus better, but it does not mean that these are independent,
divided states.
Anti-fraud risk management covers customer credit and money applications for Internet revolving
credit products. Among them, the leading fraud prevention in the credit application process includes
non-personal applications, false information, gang fraud, etc. The prominent fraud cases to be prevented
in the application of funds include account theft, account cracking, and dragging the library into the

© 2024 The Authors. This is an open access article distributed under the terms of the Creative Commons Attribution License 4.0
(https://creativecommons.org/licenses/by/4.0/).

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DOI: 10.54254/2755-2721/87/20241541

library. In this complex risk management environment, machine learning-driven fraud detection
systems have become a powerful tool that can provide effective fraud prevention and control at all
process stages and improve financial institutions' overall risk management capabilities.

2. Related work

2.1. Traditional Fraud Detection Methods

Many foreign scholars studied fraud detection relatively early, starting in the late 1980s, and gradually
developed various fraud detection methods. [2-3]In the late 1980s, researchers presented a fraud
detection case study using simple statistical techniques, one of the first attempts. This was followed by
another study for fraud detection using regression analysis methods, further advancing the field. For
credit card fraud detection in the late 1990s, a study applied distributed data mining technology to credit
card fraud detection, significantly improving detection efficiency. This method marks an essential
advancement in credit card fraud detection.
In the 21st century, credit card fraud detection methods based on cost-sensitive learning have been
proposed.[4]This method defines a performance measure that reflects the cost of a classifier within a
specific operating range and directly optimizes this performance measure through evolutionary
programming to train a classifier suitable for real-world credit card fraud detection. This innovation has
achieved remarkable results in improving the practical application effect of the classifier. In addition, a
credit card fraud detection method based on the Hidden Markov model (HMM) is also proposed. In this
approach, the researchers simulated the sequence of operations that process credit card transactions
using HMM. HMM is trained on the expected behavior of the cardholder. If HMM does not accept a
credit card transaction received with a high enough probability, it is considered fraud. This method uses
serial pattern recognition technology to provide a new perspective and method for credit card fraud
detection.
In recent years, more studies have compared various data mining techniques to credit card fraud
detection. One study used three models: random forest, support vector machine, and logistic regression,
and the results showed that random forest performed best in this process. [5]In addition, the new method
based on a cost-sensitive decision tree has better performance indicators such as accuracy and actual
positive rate on a given set of problems than the existing known methods. The method also defines a
cost-sensitive measure for credit card fraud detection. These traditional and emerging methods have laid
a solid foundation for fraud detection research and driven the continuous evolution and application of
the technology.

2.2. Application of Machine Learning in Fraud Detection

Because ML algorithms can learn from historical fraud patterns and identify them in future transactions,
fraud detection using machine learning becomes possible. Machine learning algorithms are more
efficient than humans regarding information processing speed. In addition, machine learning algorithms
can detect complex fraud features that humans cannot.
1. Work faster.[6]A rules-based fraud prevention system means creating precise written rules that
"tell" the algorithm which types of operations look normal and should be allowed and which shouldn't
because they look suspicious. However, writing rules takes a lot of time. Moreover, manual interactions
in e-commerce are so dynamic that things can change significantly in days. Here, machine learning
fraud detection methods will come in handy to learn new patterns.
2. Scale. ML methods show better performance as the data sets, they fit grow - meaning that the
more samples of fraudulent operations they accept, the better their ability to identify fraud. The
principle only applies to rules-based systems if they never evolve independently. In addition, data
science teams should be aware of the risks of rapid model scaling. If the model does not detect fraud
and incorrectly flags it, this will lead to underreporting in the future.
3. Efficiency. Machines can take over the repetitive work of routine tasks and human fraud analysis,
and experts will be able to spend their time making more advanced decisions.

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DOI: 10.54254/2755-2721/87/20241541

The recent emergence of cards with chips (EMV cards)[7] has helped reduce card fraud in Europe
but not in the United States, where the elimination process for magnetic stripe cards has been prolonged.
Furthermore, fraud models can be solved by supervised and unsupervised machine learning
algorithms. A traditional classification algorithm is used. In the second case, we can use anomaly
detection techniques. The use of neural networks is also effective, but it requires a lot of training data,
with two types of data points in equal numbers: abnormal and normal. However, in the case of fraud
detection, there is always a lack of balanced data sets.

2.3. Risk Management Framework

Under the influence of big data, the financial risk may become the ignition point of the financial crisis
at any time, and the impact and consequences of the financial crisis are tremendous, far from the specific
measures that financial institutions can solve alone. [8]Therefore, the financial industry must implement
measures at the early stage of financial risks to avoid financial crises. In their work, those working in
the financial industry must ensure the security of funds in each transaction and consider its potential to
create financial risks. The relevant personnel of financial enterprises need to keenly perceive financial
risks, control the overall development situation when dealing with financial business, and effectively
avoid financial risks.
Risk management measures mainly include four aspects. First of all, enterprise risk analysis is
conducted, transaction data in financial business is analyzed, data security is ensured, and an in-depth
analysis of ACH transaction data is conducted. Second, the staff needs to analyze business contacts and
fraud by identifying credit card holder information and verifying portrait, fingerprint, or personal
information to ensure that there is no fraud. [9-10]Third, cross-account reference analysis should be
carried out, the scope of financial business expanded, and comprehensive analysis should be conducted
through ACH transaction data. Finally, statistics and analysis of network risks are carried out so
counterparties can fully grasp the potential risks. The comprehensive application of these measures can
effectively improve the risk management capabilities of financial institutions and prevent financial risks
from evolving into financial crises.

2.4. Conclusion and Transition to Methodology

Traditional fraud detection methods have laid the groundwork for current practices by employing
statistical techniques, regression analysis, and data mining methods, achieving significant advancements
in fraud detection efficiency. The development of cost-sensitive learning and the application of Hidden
Markov Models (HMM) have further enhanced the detection of fraudulent activities. These methods,
along with new approaches like the artificial immune system and feature engineering, have progressively
improved fraud detection systems.
Machine learning (ML) [11]has revolutionized fraud detection by offering rapid, scalable, and
efficient solutions unlike rules-based systems, which require manual updates, ML algorithms can learn
and adapt from historical data, identifying complex fraud patterns that are challenging for humans to
detect. The application of ML in fraud detection ranges from supervised and unsupervised learning
algorithms to neural networks, although challenges such as imbalanced datasets remain.
Given the continuous evolution of fraud detection methods and the critical role of risk management,
the next section will explore the methodology for developing a machine learning-driven fraud detection
model. This model aims to address the complexities and dynamic nature of fraudulent activities,
leveraging advanced ML techniques to enhance the accuracy and efficiency of fraud prevention in
financial institutions.

3. Methodology
In digital financial payments, accurately predicting user payment behavior is crucial to help financial
institutions better understand user needs, manage risks, and optimize services. Ensemble learning is not
a single machine learning algorithm; it integrates multiple base learners (i.e., weak learners), eventually
forming a strong learner. [12]These base learners should have a degree of predictive accuracy and

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diversity; that is, they differ in the learning process. Decision trees and neural networks are commonly
used as base learners.

3.1. Model discussion

Decision trees are a standard machine learning method that can generate 3-5 layers of decision trees
based on selected specific variables to generate anti-fraud rules. A decision tree can decompose the
complex decision process into a series of simple steps, making the decision process more intuitive and
easier to understand. In the anti-fraud field, decision trees can be used to identify fraud, for example, to
determine whether a transaction is authentic based on the user's behavior, transaction history, and other
characteristics.
1. Random forest is an ensemble learning method that makes predictions by generating many
decision trees and taking the average of their outputs. [13-14]This approach can generate hundreds or
thousands of trees, allowing for more non-human-controlled combinations of variables and entry
threshold possibilities. This means that random forests can deal with complex fraud more flexibly and
with higher recognition accuracy.

Figure 1. Decision tree random forest model

2. In the anti-fraud field, the number of samples is usually tiny, and the fraud risk of each sample is
different. In this case, traditional machine learning methods may not accurately identify fraud due to
insufficient data volume. Therefore, it is recommended that ensemble learning methods such as random
forest be used to improve the accuracy of recognition.

3.2. Data set

The dataset used in this study is from a Kaggle challenge focused on predicting fraudulent activities in
credit card transactions. The "Credit Card Fraud Detection" dataset records transactions made by
European credit cardholders in September 2013. It contains a total of 284,807 transactions, of which
492 are fraudulent.
This study aims to explore and compare the performance of three commonly used machine learning
models: XGBoost, decision tree, and random forest on financial digital payment datasets. Therefore, by
comparing the classification prediction performance of these three models on financial digital payment
datasets, we aim to determine which model is most suitable for digital payment behavior prediction.
This dataset is commonly used in machine learning research for fraud detection due to its imbalance
between every day and fraudulent transactions, making it challenging yet representative of real-world
scenarios.

Table 1. Dataset Description

Feature Column Description
PCA Component 1 Description of PCA component 1
PCA Component 2 Description of PCA component 2

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Table 1. (continued).

... ...
PCA Component 29 Description of PCA component 29
Class Target variable indicating fraudulent (1) or normal (0) transaction

3.2.1.1. Notes
 Purpose: The dataset aims to study and predict fraudulent credit card transactions to enhance the
security of payment systems and user trust.
 Features: The transformed dataset contains 29 principal component columns derived from PCA,
representing linearly independent components of the original data.
 Feature Examples: These components may encapsulate various transaction-related factors such as
transaction amount, time, location, and other transaction details.
By presenting the dataset characteristics in this tabular format, readers can easily grasp the structure
and purpose of the data used in your study. This approach clarifies the use of PCA for dimensionality
reduction and emphasizes the focus on predicting fraudulent transactions to improve financial system
security and user confidence.

3.2.1.2. Prediction model

Random forest is a very representative Bagging integration algorithm, which is strengthened based on
Bagging. All its base learners are CART decision trees. The traditional decision tree selects the optimal
attribute in the attribute set of the current node (assuming d attributes) when selecting partition attributes.
However, in the decision tree of random forest, now the attribute set of each node randomly selects a
subset of some k attributes, and then selects an optimal feature in the subset to make the left and right
subtree division of the decision tree:
𝑘 = log 2 𝑑 (1)
In sci-kit-learn, the classification class of Random Forest is Random Forest Classifier and the
regression class is RandomForestRegressor. Parameters for parameter adaptation include two parts. The
first part is the parameters of the Bagging framework. The second part is the parameters of the CART
decision tree.
This study focuses on optimizing the Random Forest (RF) model parameters for predicting fraudulent
credit card transactions using the Kaggle dataset. The dataset comprises 284,807 transactions from
September 2013, with a significant class imbalance—492 fraudulent cases and the remaining normal
transactions. To address this imbalance, an under-sampling strategy was employed to balance the dataset
for training. The primary objective was to enhance model performance by tuning key parameters such
as estimators, adept, and min_samples_split.

3.3. Experimental design

Initially, the RF model was trained using default parameters, achieving an initial out-of-bag (OOB) score
and test AUC of 0.924 and 0.967, respectively. Subsequently, parameter optimization began with a grid
search approach. First, estimators were optimized, resulting in the selection of 50 trees for improved
performance. Next, adept was tuned to 6, followed by min_samples_split set to 5, yielding further
improvements in AUC to 0.978 and 0.982, respectively. Integrating these optimized parameters into the
final RF model significantly enhanced its predictive capabilities. The refined RF model with
estimators=50, adept=6, and min_samples_split=5 achieved an OOB score of 0.933 and a test AUC of
0.978, demonstrating notable improvements over the default settings.

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3.4. Experimental result

Figure 2. Fraud detection training results of three models

Discussion: Take the confusion matrix of the XGBoost model as an example.

 The first line is the transaction with an actual fraud value of 0 in the test set. It can be calculated that
56,861 of the fraud values are 0. Of the 56,861 non-fraudulent transactions, the classifier correctly
predicted 56,854 of them to be 0 and predicted 7 of them to be 1. This means that for 56,854 non-
fraudulent transactions, the actual churn value in the test set was 0, which the classifier also correctly
predicted. We can say that our model has classified non-fraudulent transactions and that the
transactions are good.
 The second line. There were 101 transactions with a fraud value of 1. The classifier correctly
predicted 79 of them as one and incorrectly predicted 22 of them as 0. The wrong predicted value
can be considered an error in the model.
Therefore, when comparing the confusion matrix of all models, the K-Nearest Neighbors model does
an excellent job of classifying fraudulent transactions from non-fraudulent transactions, followed by the
XGBoost model.This summary encapsulates the study's key outcomes, emphasizing the impact of
parameter tuning on improving the RF model's ability to detect fraudulent transactions in financial
digital payment systems.

4. Conclusion
With the rapid development of financial technology and the digital transformation of financial services,
applying machine learning in financial risk management is particularly important and necessary.
Especially in identifying and preventing fraudulent activities, traditional statistical methods have been
unable to meet the increasingly complex fraud detection needs.
In addition, as regulatory requirements and consumer expectations rise, financial institutions are
increasingly focused on risk management and security. Machine learning can help institutions respond
quickly to potential fraud in real-time transactions and optimize overall risk management strategies
through a data-driven approach. As a result, foreseeable future developments in the financial sector
include more efficient risk prediction and management through enhanced learning and real-time data
processing technologies, as well as the use of emerging technologies such as blockchain and secure
computing to ensure the security and trust of financial information. The application of machine learning
in financial risk management is promising, but continuous innovation and progress are needed to meet
the changing financial environment and technological challenges. Through interdisciplinary
collaboration and technological innovation, we can expect more significant progress and achievements
in fraud detection and risk management in the future.

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