Machine Learning Techniques for Fraud Detection in Financial Services
Authors: Jeyaraj Rathinaraja , Natraj N.A. , Rajasekaran M. Pallikonda , Gangadharan Kapilya 
Published: July 2024

Fraudulent activities remain a critical challenge for financial institutions, prompting a continual quest for robust detection mechanisms. While effective to a certain extent, traditional rule-based approaches often fall short of capturing fraudsters' evolving tactics. In response, the integration of machine learning (ML) techniques has emerged as a promising avenue to bolster fraud detection capabilities. This paper presents a comprehensive review of recent advancements in ML algorithms specifically tailored for fraud detection within the realm of financial services. Leveraging a plethora of methodologies, including supervised, unsupervised, and semi-supervised learning, researchers and practitioners have endeavored to devise innovative strategies to combat fraudulent transactions effectively. Supervised learning techniques, such as logistic regression, decision trees, random forests, and gradient-boosting machines, have garnered significant attention due to their ability to learn from labeled data and discern patterns indicative of fraudulent behavior. Conversely, unsupervised learning methods, including clustering and anomaly detection algorithms, strive to identify transactional data irregularities without needing labeled examples. Semi-supervised learning techniques bridge the gap between supervised and unsupervised approaches by leveraging a small set of labeled data in conjunction with a larger pool of unlabeled data to enhance detection accuracy. A pivotal aspect in the efficacy of ML models for fraud detection lies in feature engineering. Given the unique characteristics of financial data, feature selection and transformation play a vital role in capturing meaningful signals while mitigating noise. Techniques such as PCA (Principal Component Analysis), LDA (Linear Discriminant Analysis), and feature scaling are commonly employed to preprocess data and extract relevant features that encapsulate the underlying patterns of fraudulent behavior. Despite the strides made in ML based fraud detection, several challenges persist. Imbalanced datasets, wherein fraudulent transactions constitute a minority class, pose a significant hurdle, potentially leading to biased models favoring the majority class. Addressing this imbalance requires careful consideration of sampling techniques, cost-sensitive learning, and performance metrics tailored to asymmetric distributions. Furthermore, the interpretability of ML models remains a pressing concern, particularly in highly regulated industries like finance. Explainable AI (XAI) methodologies, such as SHAP (SHapley Additive exPlanations) and LIME (Local Interpretable Model-agnostic Explanations), seek to elucidate the decision-making process of complex models, fostering trust and transparency in their deployment. Looking ahead, the convergence of emerging technologies, including deep learning and blockchain, holds promise for enhancing fraud detection capabilities. Deep learning architectures, with their ability to automatically extract hierarchical features from raw data, offer potential avenues for improving detection accuracy, albeit at the cost of interpretability. Similarly, the immutable nature of blockchain technology presents opportunities for enhancing data integrity and transaction transparency, thereby fortifying fraud prevention measures.