Failure prediction models : performance, disagreements, and internal rating systems
AbstractWe address a number of comparative issues relating to the performance of failure prediction models for small, private firms. We use two models provided by vendors, a model developed by the National Bank of Belgium, and the Altman Z-score model to investigate model power, the extent of disagreement between models in the ranking of firms, and the design of internal rating systems. We also examine the potential gains from combining the output of multiple models. We find that the power of all four models in predicting bankruptcies is very good at the one-year horizon, even though not all of the models were developed using bankruptcy data and the models use different statistical methodologies. Disagreements in firm rankings are nevertheless significant across models, and model choice will have an impact on loan pricing and origination decisions. We find that it is possible to realize important gains from combining models with similar power. In addition, we show that it can also be beneficial to combine a weaker model with a stronger one if disagreements across models with respect to failing firms are high enough. Finally, the number of classes in an internal rating system appears to be more important than the distribution of borrowers across classes
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Bibliographic InfoPaper provided by National Bank of Belgium in its series Working Paper Research with number 123.
Length: 35 pages
Date of creation: Dec 2007
Date of revision:
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Basel II; failure prediction; internal ratings; model power; rating systems; ROC analysis.;
Find related papers by JEL classification:
- D40 - Microeconomics - - Market Structure and Pricing - - - General
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-01-05 (All new papers)
- NEP-BEC-2008-01-05 (Business Economics)
- NEP-RMG-2008-01-05 (Risk Management)
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