Commercial Bank Failure Prediction Models

Bank fa i lure p r e d i c t i o n mode l s have t w o ma jo r purposes. First, t h e y can p rov ide bank regulators w i t h an early w a r n i n g system tha t uses cur ren t f inanc ia l da ta t o iden t i f y fu tu re p r o b l e m institu t ions. Such a system perm i t s a m o r e e f f i c ien t al location of bank examinat ion resources, enabl ing regulators t o save ins t i tu t ions that m igh t o ther w ise fail. The d e v e l o p m e n t of an e f fec t i ve early w a r n i n g system has been t h e p r imary o b j e c t i v e of v i r tua l ly all bank fa i lure p red i c t i on studies. A l te rnat ive ly , bank fa i lure p r e d i c t i o n mode l s can he lp d e t e r m i n e w h a t var iables may b e used in imp lemen t i ng a variable-rate depos i t insurance system. The feas ib i l i ty of r isk-re lated insurance assessments d e p e n d s on t h e ex ten t t o w h i c h bank risk can actual ly b e measured. I m p l e m e n t ing an e q u i t a b l e a n d j u s t i f i a b l e v a r i a b l e r a t e p remium structure does not require exact measuremen ts of risk. Yet the re shou ld be s o m e emp i r i ca l or actuar ia l suppo r t for wha teve r system is emp l o y e d t o assign banks t o par t icu lar risk classes. Bank fa i lure p r e d i c t i o n mode l s can establ ish w h i c h f inanc ia l var iables are s ign i f icant ly re la ted t o fa i lure risk and the re fo re su i tab le as t he basis for ca lcu la t ing risk. The types of fa i lure p red i c t i on mode l s o n e chooses d e p e n d on t he pu rpose for w h i c h t hey are i n t ended . For examp le , if a m o d e l is t o be used for de te rmin ing commerc ia l bank insurance assessments, t hen there must be val id statistical e v i d e n c e of a re la t ionsh ip b e t w e e n t he f inancia l variables and bank failure risk. This is less impor tant in an early w a r n i n g system w h e r e t he p r imary ob jec t i ve is c lassi f icat ion accuracy. M o r e o v e r , in d e t e r m i n i n g w h a t m o d e l may give t h e " b e s t " results, it is i m p o r t a n t t o ascerta in the desired trade-off be tween Type I error (classif y ing a t rue fai lure as a nonfa i lure) and T y p e II error (c lassi fy ing a non fa i lu re as a fai lure). For an early w a r n i n g system s o m e emphas is shou ld be p laced on m i n i m i z i n g Type I error, s ince t he inab i l i t y t o recogn ize a fa i l ing ins t i tu t ion c o u l d p rove costly. O n t h e o ther hand, a m o d e l dev e l o p e d t o classify banks in to d i f f e ren t risk categor ies for a var iable-rate insurance scheme shou ld p lace greater emphas is on m in im i z i ng Type II error. This w o u l d he lp reduce overal l misclassi f icat ions and reduce t he n u m b e r of banks charged an insurance p r e m i u m i n tended for r iskier inst i tu t ions. W h i l e the initial impetus for the work presented in this ar t ic le c a m e f rom the FDIC's desire to exp lo re t he feas ib i l i ty of a r isk-re lated depos i t insurance p r e m i u m system, w e have presented ou r results t o e m p h a s i z e the i r use as an early w a r n i n g system. W e h o p e t he results can be usefu l u l t ima te l y in t he i m p l e m e n t a t i o n of a var iab le-rate p r e m i u m system as we l l as in the d e v e l o p m e n t of a m o r e e f fec t i ve early warn ing system. Related t o these t w o p r imary ob jec t i ves were several ques t ions w e sought t o answer. 1. To wha t ex ten t w o u l d p red i c t i on models that i nco rpo ra te exam ina t i on repor t data imp rove classi f icat ion accuracy over tha t wh ich c o u l d b e o b t a i n e d f r o m m o d e l s based solely on call repor t 2 data? 2. H o w qu ick l y w o u M a mode l ' s overa l l classif i ca t ion accuracy de te r io ra te as t he lead t ime before a fai lure was lengthened, and d o examina t ion based m o d e l s h o l d up o v e r t i m e as wel l as cal l -based models? 3. H o w d o t he fa i lure p red i c t i on models d e v e l o p e d in this s tudy p e r f o r m w i t h respect t o mode l s d e v e l o p e d in t he past, a n d d o they