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Failure prediction models: performance, disagreements, and internal rating systems

Janet Mitchell () and Patrick Van Roy ()
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Janet Mitchell: National Bank of Belgium, Financial Stability Department

No 123, Working Paper Research from National Bank of Belgium

Abstract: We 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

Keywords: Basel II; failure prediction; internal ratings; model power; rating systems; ROC analysis. (search for similar items in EconPapers)
JEL-codes: D40 G21 G24 G28 G33 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2007-12
New Economics Papers: this item is included in nep-bec and nep-rmg
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