1 s2.0 S0377221706008769 Main

European Journal of Operational Research 180 (2007) 128 www.elsevier.
com/locate/ejor
Invited Review
Bankruptcy prediction in banks and rms via statistical and intelligent techniques A review
P. Ravi Kumar, V. Ravi
*
Institute for Development and Research in Banking Technology, Castle Hills Road # 1, Masab Tank, Hyderabad 500 057 (AP), India Received 19 July 2005; accepted 11 August 2006 Available online 17 November 2006
Abstract This paper presents a comprehensive review of the work done, during the 19682005, in the application of statistical and intelligent techniques to solve the bankruptcy prediction problem faced by banks and rms. The review is categorized by taking the type of technique applied to solve this problem as an important dimension. Accordingly, the papers are grouped in the following families of techniques: (i) statistical techniques, (ii) neural networks, (iii) case-based reasoning, (iv) decision trees, (iv) operational research, (v) evolutionary approaches, (vi) rough set based techniques, (vii) other techniques subsuming fuzzy logic, support vector machine and isotonic separation and (viii) soft computing subsuming seamless hybridization of all the above-mentioned techniques. Of particular signicance is that in each paper, the review highlights the source of data sets, nancial ratios used, country of origin, time line of study and the comparative performance of techniques in terms of prediction accuracy wherever available. The review also lists some important directions for future research. 2006 Elsevier B.V. All rights reserved.
Keywords: Bankruptcy prediction; Banks; Firms; Statistics; Neural networks; Fuzzy logic; Case-based reasoning; Decision trees; Evolutionary approaches; Operations research; Rough sets; Support vector machine and soft computing; Intelligent techniques
1. Introduction The prediction of bankruptcy for nancial rms especially banks has been extensively researched area since late 1960s [3]. Creditors, auditors, stockholders and senior management are all interested in bankruptcy prediction because it aects all of them alike [121]. The health of a bank or rm in a highly competitive business environment is dependent
Corresponding author. Tel.: +91 40 23534981; fax: +91 40 23535157. E-mail addresses: vravi@idrbt.ac.in, rav_padma@yahoo.com (V. Ravi).
*
upon (i) how nancially solvent it is at the inception, (ii) its ability, relative exibility and eciency in creating cash from its continuous operations, (iii) its access to capital markets and (iv) its nancial capacity and staying power when faced with unplanned cash short-falls. As a bank or rm becomes more and more insolvent, it gradually enters a danger zone. Then, changes to its operations and capital structure must be made in order to keep it solvent (http://www.solvency.com/solvency.htm). The most precise way of monitoring banks is by conducting on-site examinations. These examinations are conducted on a banks premises by regulators every 1218 months, as mandated by the
0377-2217/$ - see front matter 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.ejor.2006.08.043
P. Ravi Kumar, V. Ravi / European Journal of Operational Research 180 (2007) 128
Federal Deposit Insurance Corporation Improvement Act of 1991. Regulators utilize a six part rating system to indicate the safety and soundness of the institution. This rating, referred to as the CAMELS rating, evaluates banks according to their basic functional areas: capital adequacy, asset quality, management expertise, earnings strength, liquidity and sensitivity to market risk. While CAMELS ratings clearly provide regulators with important information, Cole and Gunther [20] reported that these CAMELS ratings decay rapidly. Fraser [30] noted that banks perform better by holding relatively more securities and fewer loans in their portfolios. Gady [32] and Fraser [30] showed that core deposit funding is benecial for banks, particularly demand deposits, which are non-interest bearing. Gady [32] has indicated that high-performance banks are able to generate more interest or non-interest income than under performing banks. Wall [117] observed that higher prot banks rely more on equity funding. Brewer et al. [15] observed that rms used the derivative instruments to change their risk exposure. They also concluded that there was a negative correlation between risk and derivatives usage. Haslem et al. [44] determined the impact of types of strategies followed by individual banks related to the relative protability performance. Kwast and Rose [60] employed statistical cost accounting techniques to examine the relationship between bank protability and pricing and operating eciency. This paper presents a comprehensive survey of a number of research works published during 1968 2005, where various statistical and intelligent techniques were applied to solve bankruptcy prediction problem in banks and rms. The usefulness of the current review paper is that the papers are categorized, primarily, according to the technique employed therein. This aspect paves the way for the researchers from the statistical and the articial intelligence/soft computing community to shift focus on this exciting problem of bankruptcy prediction by applying their newest and novel ideas. This will only enhance and enrich the bankruptcy prediction research further as these researchers are likely to come out with robust and high performing models. The review paper is aimed at attracting fresh graduates, researchers and academics from nance, banking, statistics and articial intelligence/soft computing, since bankruptcy prediction is a multi-disciplinary area. The current review is dierent from the earlier reviews, presented in Sec-
tion 3, in the following aspects: (i) It is categorized with respect to the techniques employed. (ii) It is by far, the most comprehensive and organized with respect to various dimensions of review such as the nancial ratios used, source of data set, country of origin, time line of study, type of industry viz., bank or rm as detailed in Tables 2 and 3. (iii) It also gives the reader a brief overview of the techniques employed. (iv) It gives the reader an unbiased comparison of the statistical and intelligent techniques. (v) It can be considered as a starting point to pursue research in bankruptcy prediction. 1.1. Earlier reviews This section presents an overview of the review papers published earlier on bankruptcy prediction. Scott [99] reviewed several empirical and theoretical models and found a substantial amount of overlap between these two lines of research. He concluded that the success of empirical models suggested the existence of a strong underlying regularity, though they are not based on explicit theory. Dimitras et al. [25] presented a review of the articles published during 19321994 in various journals specialized in accounting, nance, operation research and decision science. They selected 47 articles restricted to (i) journal articles that presented models and (ii) industrial and retail applications. Their framework of study was based on the country, year of publication, industry type, sample periods and method. They reviewed a total of 59 models and variables used in these articles. OLeary [84] proposed a meta analysis of the use of neural networks to predict corporate failure. His review was across dimensions such as the software used, the input variables, the nature of the hidden layer used, number hidden nodes and statistical analysis of results. Tay and Shen [110] reviewed the application of various rough set based models to bankruptcy prediction and concluded that rough set models were promising alternative to conventional methods. Daubie and Meskens [23] reviewed the prediction models applied to business failure in banks and rms. They discussed the causes, symptoms, process and remedies of failure. They reviewed papers published during 19682000 in journals specialized in accounting, nance, operations research and decision science. Calderon and Cheh [17] reviewed the applications of neural networks in bankruptcy prediction. For every study they presented the number of input variables, learning sample size, testing sample size and
software used. They explained the comparative eciency of dierent techniques. The rest of the paper is organized as follows: Section 2 presents an overview of the intelligent techniques. Section 3 reviews papers dealing with statistical techniques while Section 4 presents the works employing various NN architectures. Section 5 presents CBR applications while Section 6 describes decision tree applications to the problem. Section 7 reviews the applications of evolutionary approaches and Section 8 presents applications of operational research to the problem. Section 9 presents the papers employing rough sets and Section 10 describes the application of other techniques subsuming fuzzy logic, support vector machine and isotonic separation to the problem. Finally, Section 11 presents the soft computing applications. Section 12 presents some of the important insights that emerged out of the survey. Section 13 suggests some future research directions in the eld and concludes the review. 2. Review methodology As mentioned earlier, the review is conducted in two broad categories: (i) statistical and (ii) intelligent techniques. Among statistical techniques, the methods covered are: linear discriminant analysis (LDA), multivariate discriminate analysis (MDA), quadratic discriminant analysis (QDA), logistic regression (logit) and factor analysis (FA). The intelligent techniques covered in the study belong to (i) dierent neural network (NN) architectures including multi-layer perception (MLP), probabilistic neural networks (PNN), auto-associative neural network (AANN), self-organizing map (SOM), learning vector quantization (LVQ) and cascade correlation neural network (Cascor), (ii) decision trees, (iii) case-based reasoning, (iv) evolutionary approaches, (v) rough sets, (vi) soft computing (hybrid intelligent systems), (vii) operational research techniques including linear programming (LP), data envelopment analysis (DEA) and quadratic programming (QP), (viii) other intelligent techniques including support vector machine, fuzzy logic techniques. Under each category, the papers are reviewed in the chronological order. Thus the most important dimension of the present review is the type of techniques applied. The review is conducted across other dimensions also such as (i) study pertaining to bank or rm (type of rm if mentioned), (ii) source of data, (iii) various nancial
ratios used as explanatory variables, (iv) the years during which data was collected, (v) number of years prior to which prediction was made (if available) and (vi) results obtained (when available in concise form) in each study. Further, the review concentrated on the papers published in peerreviewed journals/international conferences/edited volumes in the areas of accounts, nance, management, operational research, neural networks, expert systems and decision support systems. All the unpublished works in terms of Ph.D. thesis, working papers and internal reports are excluded from the scope of the review. Moreover, in a paper, when multiple techniques are compared in their standalone mode, the technique proposed in that paper is taken as the main criterion and accordingly the paper is categorized in that family. For example, when in a paper, NN, DA and logit (logistic regression) are compared in their stand-alone mode and NN is proposed in that paper, then the paper is reviewed under the NN section. The present review indicates that neural networks family with 25 papers is the most widely applied technique. The soft computing family with 15 papers and statistical family with 11 papers follow this. Then, rough sets were applied in six papers and other techniques accounted for ve papers, while CBR and OR techniques had four papers each. Also, evolutionary approaches and decision trees gured in three and two papers, respectively. Further, ve earlier review papers are also included in the current review. Table 1 presents the main idea behind the intelligent techniques, their advantages and disadvantages. Table 2 lists the nancial ratios used in each of the papers. Table 3 presents for all papers, the details such as the entity for which the study was done banks or rms; source of data; country of origin; sample size; techniques used in the study and the time line of the study and the number of years prior to prediction, wherever available. 2.1. Overview of intelligent techniques 2.1.1. Fuzzy set theory Fuzzy set theory, proposed by Zadeh [124], has found a number of applications. It is a theory of graded concepts. It provides a mathematical framework where vague, conceptual phenomena can be rigorously studied [127]. Fuzzy logic models human experiential knowledge in any domain. When applied to solve process control or prediction problems fuzzy logic takes the help of the knowledge of
Table 1 Merits and demerits of intelligent techniques Technology 1 FL Basic idea Models imprecision and ambiguity in the data using fuzzy sets and incorporates the human experiential knowledge into the model Advantages Good at deriving human comprehensible fuzzy ifthen rules; It has low computational requirements Disadvantages Arbitrary choice of Membership function skews the results, although triangular shape is the most often used one. Secondly, the plethora of choices for membership function shapes, connectives for fuzzy sets and defuzzication operators are the disadvantages The determination of various parameters associated with training algorithms is not straightforward. Many neural network architectures need a lot of training data and training cycles (iterations) Does take long time to converge; May not yield global optimal solution always unless it is augmented by a suitable direct search method Cannot be applied to large data sets; poor in generalization It can be (a) sometimes impractical to apply as it may lead to an empty set (b) sensitive to changes in data and (c) inaccurate Selection of kernel and its parameters is a tricky issue. It is abysmally slow in test phase. It has high algorithmic complexity and requires extensive memory Over tting can be a problem. Like neural networks, they too require a lot of data samples in order to get reliable predictions
NN
Learn from examples using several constructs and algorithms just like a human being learns new things
Good at function approximation, forecasting, classication, clustering and optimization tasks depending on the neural network architecture
GA
Mimics Darwinian principles of evolution to solve highly nonlinear, non-convex global optimization problems Learns from examples using the euclidean distance and k-nearest neighbor method They use lower and upper approximation of a concept to model uncertainty in the data It uses statistical learning theory to perform classication and regression tasks
Good at nding global optimum of a highly nonlinear, non-convex function without getting trapped in local minima Good for small data sets and when the data appears as cases; similar to the human like decision-making They yield ifthen rules involving ordinal values to perform classication tasks It yields global optimal solution as the problem gets converted to a quadratic programming problem; It can work well with few samples Many of them can solve only classication problems while CART solves both classication and regression problems. They yield human comprehensible binary if then rules It has found numerous applications and gives exact solution
CBR
Rough sets
SVM
Decision trees
They use recursive partitioning technique and measures like entropy to induce decision trees on a data set
DEA
SC
It uses linear programming to rank various alternatives/business units according to some input and out variables Hybridizes fuzzy logic, neural networks, genetic algorithms, etc. in several forms to derive the advantages of all of them
It yields only relative scoring of the business units and not absolute ratings Apparently, it has no disadvantages. However, it does require good amount of data, which is not exactly a disadvantage nowadays
It amplies the advantages of the intelligent techniques while simultaneously nullifying their disadvantages
the domain expert and employs fuzzy mathematics to come out with fuzzy inference systems. Fuzzy logic can also be used to derive fuzzy ifthen rules from data to solve classication problems. 2.1.2. Neural networks Neural networks [62,72] oer a computational paradigm inspired by biological neural networks of human nervous system. A neural network is a
system of massively parallel, interconnected computing units called neurons, arranged in layers. The neural networks found extensive applications in nancial services. The multi-layer perceptron (MLP) [95], radial basis function network (RBFN) [81], probabilistic neural network (PNN) [104], cascade correlation neural network (Cascor) [28], learning vector quantization (LVQ) [35,56], selforganizing feature map (SOM) [56] are some of
P. Ravi Kumar, V. Ravi / European Journal of Operational Research 180 (2007) 128 Table 2 Financial ratios (variables) in each paper Ref # [1] Variables
[2] [5] [6] [7] [8]
[9] [11]
[12]
[13] [16]
[18]
[19] [24] [26]
[29] [31] [36] [37]
[44]
Cash ow/total liabilities, current assets/current liabilities (current ratio), inventories turnover, net income/total sales, net income/total assets, net working capital/total assets, owners equity/total assets, (total borrowings + bonds payable)/total assets Net income/total assets (return on assets (ROA)), net loan losses/adjusted assets, net loan losses/total loan, (net loan losses + provision for loan losses)/income, non-performing loans/total assets Common equity/total capital (capitalization), cumulative protability, debt services, stability of earnings, roa, liquidity, size Debt cost, debt quality, growth, indebtedness, share of labour costs, short-term liquidity, size, turnover of assets Book value/total assets, cash ow/total assets, gross operating income/total assets, ROA, price/cash ow, rate of change of cash ow per share (ROC), rate of change of stock price, stock price volatility Cash/current liabilities, cash/net sales, cash/total assets, cash ow/current liabilities, cash ow/total assets, cash ow/total debt, current ratio, current assets/net sales, current assets/total assets, current liabilities/equity, earnings before interest and taxes (EBIT)/total interest payments, equity/xed assets, equity/net sales, inventory/net sales, long-term debt/equity, market value of equity/book value of debt, net income/total assets, net quick assets/inventory, net sales/total assets, operating income/total assets, quick assets/current liabilities, quick assets/net sales, quick assets/total assets, rate of return/common stock holders, retained earnings/total assets, return on stock, total debt/equity, total debt/total assets, working capital/equity, working capital/net sales, working capital/total assets EBIT/total assets, market capitalization/total debt, retained earnings/total assets, sales/total assets, working capital/total assets Complexity of capital structure, degree of competitiveness, rm age, fraud, intangible assets/net sales, natural log of total assets deated the gross domestic product, ROA, ownership concentration, past losses, resignation, secured interest bearing debt/ total liabilities, total interest bearing debt/total liabilities Agricultural loans/total assets, commercial real estate loans/total assets, construction loans/total assets, income before extra items, large time deposits/total assets, insiders loans over net loans, natural log(total assets), net charge os/total loans, ROA, net interest income/total assets, net loans/total assets, non-interest income/total assets, non-performing loans/primary capital, non-performing loans/total assets, past due loans/gross loans, primary capital/adjusted assets, provision for loan losses/total assets, restructured loans/gross loans, return on equity, security gains (losses) and extra items/total assets, short-term assets less large liabilities/total assets, total capital/total loans, total equity capital, total overhead expenses/total assets, undivided prot and capital reserve to total assets, yield on total assets Cash ow/total debt, current ratio, current liabilities/total debts, gross prot/sales, net income/stockholders equity, roa, sales/ total assets Cash/current liabilities, cash/total assets, cost of goods sold/inventory, current ratio, current assets/total assets, current assets/ total sales, current liabilities/total assets, EBIT/total assets, inventory/sales, net income/net worth, net income/sales, ROA, quick assets/sales, quick assets/total assets, retained earnings/inventory, retained earnings/total assets, sales/cash, sales/net worth, sales/total assets, total assets/gross national product (GNP) price-level, total liabilities/net worth, total liabilities/total assets, working capital/sales Quick ratio, income ratio, interest expenses/average non-protable assets, interest expenses/average protable assets, interest expenses/total expenses, interest income/interest expenses, liquid assets/(deposits + non-deposit funds), liquid assets/total assets, net working capital/total assets, (salary and employee benets + reserves for retirement)/no of personnel, (shareholders equity + total income)/(depreciation + non-depreciation funds), (shareholders equity + total income)/total assets, (shareholders equity + total income)/(total assets + contingencies and commodities), standard capital ratio Cash/restricted current assets, equity ratio(equity/total assets), expired taxes, retained earnings/total assets, inventories, gross return, coverage of debt, net return, current ratio, quick ratio, debt ratio Abnormal increase in inventory and receivables, quick ratio, current ratio, debt/equity, dividend, funds ow ratio, ROA, net worth, sales/total assets, total assets, trend in net income, working capital/total assets Current ratio, current liabilities/total assets, gross prot/total assets, inventories/working capital, (long-term debt + current liabilities)/total assets, net income/gross prot, ROA, net worth/(net worth + long-term debt), quick assets/current liabilities, working capital/net worth Quick ratio, current ratio, income ratio (income/working capital) Cash ow/total debt, current ratio, current assets/total assets, EBIT/total assets, log(interest coverage + 15), log (total assets), market value of equity/total capitalization, ROA, quick assets/current liabilities, quick assets/total assets Working capital/total assets, retained earnings/total assets, EBIT/total assets, market value of equity/total assets, sales/total assets EBIT/total assets, net income/net worth, total liabilities/total assets, total liabilities/cash ow, interest expenses/sales, general and administrative expensive/sales, managers work experience, rms market niche position, technical structure facilities, organization-personnel, competitive advantage of rms, market exibility Domestic cash, domestic investment securities, foreign cash, foreign investment securities, net domestic loans, net foreign loans, net income, total assets, total domestic interest bearing deposits, total domestic non-interest-bearing deposits, total equity capital, total foreign interest bearing deposits, total foreign non-interest bearing deposits (continued on next page)
6 Table 2 (continued) Ref # [45] [51] Variables
[53]
[55] [57]
[62] [64]
[65]
[66] [67]
[69]
EBIT/total assets, market value of equity/total debt, retained earnings/total assets, sales/total assets, working capital/total assets Net operating cash ow to total assets, cash resources to total assets, cash ow cover (net operating cash ow to annual interest payments), sales revenue to total assets, total debt to total equity, total debt to gross operating cash ow, working capital to total assets (wc = current assets current liabilities) Gross prot margin ((net sales-cost of goods sold)/net sales), market value of common stock, natural logarithms of tangible asset turnover, (net income + depreciation)/number of shares, (cash ow per share), net income/total of common equity (earnings per share), sales/cash, sales/inventories, sales/receivables, total debt/total assets, total debt/total capital, working capital/total assets Equity ratio (equity/total assets), net income before depreciation and extraordinary items, net income before depreciation and extraordinary items of the previous year, operating margin Allowance for loan losses/total assets, bank holding companies total assets, bank total assets/bank holding co. (bhc) total assets, certicate of deposit/total deposits, maximum change in assets/mean assets, maximum change in assets/mean change assets, maximum change in loans past due at least 90 days/mean of numerator, net income after taxes/total assets, net interest income/total assets, net loan charge-os/total assets, non-deposit liabilities/total liabilities, provision for loan losses/total assets, sum of key asset accounts/total assets, total assets, total equity/total assets, total loans and leases/total assets, total securities/total assets EBIT/total assets, market value of equity/book value of debt, retained earnings/total assets, sales/total assets, working capital/ total assets Capital expenditure, common shares traded, consumer price index, current account balance/gross domestic product, current assets/common shareholders equity, depreciation expenses, dividend/share, earnings/share, eective exchange rate, federal budget/gross domestic product, government spending/gross domestic product, (long-term debt + short-term debt)/total assets, market capitalization, money supply, net income/net sales, net sales/total assets, pre-tax income/net sales, purchase price of crude oil, relative strength index, research expenses, short-term interest rate, spread between short-term and long-term interest rate, tax deferral and investment credit, total sources of fund/ total uses of fund, trade balance/gross domestic product Quick ratio, cash ow/sales, cash ow/stock holders equity, cash ow/total assets, cash ow/total borrowings and bond, change in payable/receivables, change in inventory/current assets, change in inventories turnover, change in payables/ current liabilities, current ratio, current ratio trend, debtos ratio (days) (debtors * 365 days/sales), dividend/capital stock, nancial expenses/sales, xed assets/(stockholders equity + long-term liabilities), xed assets turnover, xed asset composition, xed liability ratio, xed ratio, gross prot/sales, growth rate of xed asset, growth rate of net income, growth rate of ordinary income, growth rate of sales, growth rate of total liabilities, growth rate of total assets, interest coverage ratio, interest ratio, inventory/current assets, inventories turnover, net income/capital stock, net income/sales, net income/ stockholders equity, net income/total assets, net working capital/total assets, net working capital turnover, operating income/sales, ordinary income/business capital, ordinary income/sales, ordinary income/stockholders equity, ordinary income/total assets, payable/current liabilities, payables/inventories, payables/receivables, stock holders equity/total assets, stock holders equity turnover, total assets turnover, (total borrowings + bonds payable)/total assets, total liability composition EBIT/total assets, market capitalization/total debt, retained earnings/total assets, sales/total assets, working capital/total assets Average market equity/total capital, auditor, auditor opinion, bond rating, book equity/total capital, quick ratio, cash ow/ xed charges, cash ow/share, cash ow/total debt, cash ow margin, capital expenditure/share, capital lease, cost of goods sold/sales, current ratio, current liabilities/total liabilities, dividend, earnings/5 years maturity, earnings/total debt, earnings before interest and taxes (EBIT) drop, EBIT/sales, EBIT/share, EBIT/total assets, EBIT/total tangible assets, xed charge coverage, interest coverage, inventory turnover, log (interest coverage), log (total assets), long-term debt/equity, margin drop, market equity/total capital, market value/total liabilities, net available for capital/total capital, net available for total capital/ sales, ROA, net income/total debt, net prot margin, number of employees, operating income/sales, price/earning ratio, quick assets/sales, receivables turnover, retained earnings/total assets, retained earnings/tangible assets, sales/cash, sales/gross xed assets, sales/receivables, sales/total assets, sales/total capital, sales/total tangible assets, standard deviation (EBIT/total assets), standard deviation (log (EBIT/total assets)), total debt/total assets, total debt/total capital, total investment, working capital/ long-term debt, working capital/total assets, worth/total debt Average salary/employee, borrowing ratio, quick ratio, cash ratio(cash and market securities/total liabilities), cash earnings/ share, cash ow margin, capital employed/employee, capital gearing, coverage debt, creditors ratio (days)(creditor * 365 days/ cost of sales), creditors turnover, current ratio, debtos ratio (days)(debtors * 365 days/sales), debtos turnover, earnings margin, nancial debt ratio, gross return, income gearing, inventories, net prot margin, net return, operating prot margin, operating prot/employee, pre-tax prot margin, preferences and loan/equity and reserves, quick assets/total assets, return on capital employed, return on long-term capital, return on net xed assets, return on shareholders capital, return on shareholders equity, sales/employee, stock ratio (days), stock turnover, tax ratio, trading prot margin, turnover/assets employed, turnover/ xed assets, turnover/net current assets, working capital/total assets
P. Ravi Kumar, V. Ravi / European Journal of Operational Research 180 (2007) 128 Table 2 (continued) Ref # [70] Variables
[71]
[73] [74] [75] [78]
[79]
[83]
[85] [86]
[88] [89]
[92] [97]
[98] [100]
Auditor opinion, audit qualication, cash/total assets, cash/current liabilities, commercial paper rating, current ratio, current assets/net sales, current assets/total assets, debt rating, funds ow/total liabilities, net income/total assets, net worth, number of years of nancial statements in database, number of consecutive years negative net income, number of consecutive years sales decline, quick assets/current liabilities, sales, sales/total assets, sales/working capital, standard deviation of common stock rate of return, stock exchange, total liabilities/net worth, total liabilities/total assets, working capital/total assets, yearly dividend Charge-os/(net operating income + loss provision), commercial and industrial loans/total loans, dividends/net income, equity capital/adjusted risk assets, gross capital/adjusted risk assets, gross capital/risk assets, gross charge-os/(net operating income + loss provision), liquid assets/total sources of funds, loans/total assets, loans and leases/total sources of funds, loss provision/(loans + securities), roa, net income/total assets, net interest margin/earning assets, net interest margin (taxable equivalent)/earning assets, net liquid assets/total assets, non-interest expenses/operating revenue, operating expenses/operating revenues, total assets, total operating expenses/operating revenue Accounts receivables/sales, cash/total assets, current ratio, current assets/total assets, current assets/sales, inventory/cost of goods sold, long-term debt/total assets, ROA Cash/current liabilities, investment cash ow/net income, rm size, ROA Cash/current liabilities, coded to indicate opinion type, current ratio, dividends/net income, rm size, investment cash ow/net income, leverage, ROA, Operating cash ow/net income, retained earnings/total assets, sales/total assets Current ratio, current liabilities/total assets, gross prot/total assets, inventories/working capital, (long-term debt + current liabilities)/total assets, net income/gross prot, net income/net worth, ROA, net worth/net xed assets, net worth/(net worth + long-term debt), quick assets/current liabilities, working capital/net worth Break even point ratio, bonds payable, cash ow/interest expenses, cash ow/(previous years short-term loan), cash ow/shortterm loan, cash ow/total debt, cash ow/total loans, capital stock turnover, depreciation ratio, EBIT/sales, xed assets/ (stockholders equity + long-term liabilities), xed assets turnover, xed ratio, gross value added/(property, plant and equipment), gross value added/sales, gross value added/total assets, growth rate of tangible assets, interest coverage ratio, interest expenses/total borrowings, interest expenses/total expenses, interest expenses/sales, inventories turnover, net income/sales, net income/stockholders equity, ROA, net interest expenses/sales, operating assets turnover, ordinary income/ordinary expenses, ordinary income/sales, ordinary income/stockholders equity, ordinary income/total assets, payable turnover, productivity of capital, solvency ratio, stock holders equity/total assets, stock holders equity turnover, tangible assets turnover, total assets turnover, (total borrowings + bonds payable)/total assets, variable cost/sales Current liabilities/current assets, funds provided by operations/total liabilities, log (total assets/GNP price-level index), net income/total assets, one if total liabilities exceeds total assets, zero otherwise, one if net income was negative for the last two years, otherwise zero, total liabilities/total assets Cash ow/total loans, coverage debt, current assets/total assets, current assets-cash/total assets, net income/loans, ROA, net income/total equity capital, reserves/loans Quick ratio, nancial expenses/sales, xed assets/(stockholders equity + long-term liabilities), gross value added/tangible xed assets, gross value added/sales, growth rate of property, plant and equipment, growth rate of sales, growth potential, rm history, industry position, industry reputation, international competitive advantage, market niche/trend, operating assets turnover, operating income/total assets, ordinary income/total assets, past payment record, personnel and sta hiring policy, pricing competitive advantage, prot perspective, quality of management, relationship between labour and capital, size, stockholders equity/total assets, technology development and quality innovation, total assets turnover, (total borrowings + bonds payable)/total assets, working conditions and welfare facilities Current ratio, EBIT/interest expenses, EBIT/total assets, market value of equity/book value of debt, retained earnings/total assets Cash at year end/total debt, cash ow/total debt, charge in inventories, charge in net nancials, charge in net other assets and liability, charge in other current assets, charge in other current liabilities, charge in payables, charge in receivables, current ratio, current ratio trend, dividend, earnings trend, xed coverage expenditure, long-term debt/net worth, net income/sales, ROA, net investment ow, net operating ow, quick assets/current liabilities, quick assets/sales, sales trend (number consecutive years of sales decline, total debt/total assets, trend of cash ow/total debt, trend of net income/sales, trend of net income/total assets, trend of working capital/sales, working capital/sales EBIT/total assets, market value of equity/total debt, retained earnings/total assets, sales/total assets, working capital/total assets Cash/current liabilities, cash/total assets, cash ow/total assets, cash ow/total debt, current ratio, current assets/total assets, current assets/total sales, current liabilities/equity, EBIT/total assets, equity/sales, inventory/sales, market value of equity/total capitalization, market value of equity/total debt, ROA, net income/total capitalization, quick assets/current liabilities, quick assets/total assets, quick assets/total sales, retained earnings/total assets, sales/total assets, total debt/total assets, working capital/sales, working capital/total assets GAAP (generally accepted accounting principals) net worth/total assets (GNWTA), repossessed assets/total assets (RATA), net income/gross income (NIGI), net income/total assets (NITA), cash securities/total assets (CSTA) EBIT/total assets, market value of equity/total debt, retained earnings/total assets, sales/total assets, working capital/total assets (continued on next page)
8 Table 2 (continued) Ref # [101] [102] [104] [106] Variables
[108]
[110]
[114] [115]
[116] [119]
[121] [122] [124] [126] [128]
EBIT/total assets, market value of equity/total debt, retained earnings/total assets, sales/total assets, working capital/total assets Quick ratio, current liabilities/total assets, nancial expenses/sales, liquidity ratio, net income/stockholders equity, operating income/operating expenses, retained earnings/total assets, stock holders equity/total assets, value added/total cost Current ratio, EBIT/interest expenses, EBIT/total assets, market value of equity/book value of debt, retained earnings/total assets Allowance for loan losses/total loans, asset growth, branch or unit bank, charter, core deposits/total assets, deposit insurance, earning assets/total assets, federal reserve bank member, gains (losses) from sale of securities/total assets, holding company aliation, interest income/total assets, (non-interest expenses-salary)/total assets, non-interest income/total assets, nonperforming assets/total assets, o balance sheet commitments/total assets, provision expenses/total loans, regional geographical region, salary/total assets, total equity/total assets, total interest expenses/total assets, total loans/total assets, total securities/ total assets, volatile liabilities/total liabilities (Agriculture production and farm loans + real estate loans secured by farm land)/net loans and leases, (cash + US treasury and government agency obligations)/total assets, capital/assets, commercial and industrial loans/net loans and leases, (federal funds sold + securities)/total assets, (interest and fees on loans + income from lease nancing)/net loans and leases, loans to individuals/net loan and leases, net charge os/average loans, ROA, provision for loan loses/average loans, return on average assets, total expenses/total assets, total income/total expenses, total interest paid on deposits/total deposits, total loans 90 days or more past due/net loans and leases, total loans and leases/total assets, total loans and leases/total deposits, total non-accrual loans and leases/net loans and leases (Agriculture production and farm loans + real estate loans secured by farm land)/net loans and leases, (cash + US treasury and government agency obligations)/total assets, capital/assets, commercial and industrial loans/net loans and leases, (federal funds sold + securities)/total assets, (interest and fees on loans + income from lease nancing)/net loans and leases, interest income/ total assets, loans to individuals/net loan and leases, net charge os/average loans, net income/total assets, provision for loan loses/average loans, real estate loans/(net loan & leases), return on average assets, total expenses/total assets, total interest paid on deposits/total deposits, total loans 90 days or more past due/net loans and leases, total loans and leases/total assets, total loans and leases/total deposits, total non-accrual loans and leases/net loans and leases After tax prot/total assets, cash/total liabilities, working capital/operational expenditure (Average tangible xed assets-average construction in progress)/number of employees, current ratio, interests, discounts and bond issue expenses/sales, interests, discount expenses/value added, liquid assets/current liabilities, non-operating expenses/ sales, operating capital/number of employees, operating income/operating capital, ordinary income/sales, value added/ operating capital Asset (loan) quality, earnings, liquidity, management, miscellaneous (Cash + US treasury securities + federal funds sold and securities purchased under agreements to resell)/total assets, (certicate of deposit over $100,000 + federal funds sold and securities purchased under agreements to repurchase)/total assets, commercial and industrial loans/total loans, doubtful loans/total capital, equity capital/total assets, (nance agriculture loans + farmers loans + real estate loans secured by farmland)/total assets, loans believed to be uncollectable/total capital, loans to individuals for household, family and other personal expenditure/total loans, net income/equity capital, ROA, real estate loans secured by 14 family residential properties/total loans, real estate loans secured by non-farm non-residential properties/total loans, substandard loans/total capital, total time and savings deposits/total deposits, total assets, total interest paid on deposits/total deposits, total loans/(equity capital + reserve for loan losses), total loans/savings, total operating expenses/total assets EBIT/total assets, market value of equity/total debt, retained earnings/total assets, sales/total assets, working capital/total assets Current liabilities/total debts, exploration expenses/total reserves, net cash ow/total assets, total debt/total assets, trend in total reserves Debt/gross cash ow, earnings after abnormals /total assets, payout on operating prot before abnormals and tax, pre-tax prot/total assets, working capital/total assets Current ratio, EBIT/total assets, market value of equity/total debt, retained earnings/total assets, sales/total assets, working capital/total assets Current ratio, ROA, total debt/total assets
the popular neural network architectures. They dier in aspects including the type of learning, node connection mechanism, the training algorithm, etc. Since, LVQ and Cascor are not very often used networks, their brief overview is presented as follows:
LVQ has its origin in vector quantization (VQ), the main form of competitive learning neural network. In VQ, each of the competitive units corresponds to a cluster center and the error function is the sum of squared euclidean distance between each training case and the nearest center. LVQ is used to
Table 3 Other details of each paper Ref # [1] [2] [4] [5] [6] [7] [8] [9] [10] [11] Bank/rm Firms Banks Firms Firms Firms Firms Firms Firms Firms Source of data/country of origin Korea, KIS (Korea Information Service)* USA, FDIC Annual report* Italy Spanish USA Finnish Korea Data used by Johnson and Wicherns [50]* [Standard and Poors COMPUSTAT database, Lexis/Nexis, Moodys Industrial Report, Commerce Clearing Houses Capital Change Reporting and The Wall Street Journal, General Council of SEC, CRSP]* Texas, [FDIC (Federal Deposit Insurance Corporation, Shesunho & Co)]* Data taken from UCI machine learning repository* Data used by Greco et al. [39]* Standard and Poors COMPUSTAT database* Turkish Belgium, [Chambers of Commerce, CD-Rom National Bank of Belgium]* Standard and Poors COMPUSTAT database* Greece, Greek USA Data used by Gentry et al. [34] Standard and Poors COMPUSTAT database* Data used by Altman [3]* Greece, Greek industrial development bank (ETEVA)* #Samples 2400 100 3465 111 5671 1160 74 662 237 Techniques used DA, BPNN, RNN1, RNN2, Hybrid I, Hybrid II CNN, SONN, Fuzzy clustering BPNN, LDA ZETA analysis LDA, logit, multi-level perceptron, Fuzzy rule base BPNN with novel indicators DA/DA, LA/LA, GA/BPNN, DA/ BPNN, LA/BPNN Auto-associative NN LP to quadratic transformation, QDF BPNN, NPDA, logit Timeline of dataset 19941997 1991 19821992 (1 year) 19691975 3 years 19861989 19942000 19801991
[12] [13] [14] [16] [18] [19] [24] [26] [27] [29] [31] [36] [37] [38]
Banks Firms Firms Firms Banks Banks Firms Firms Law cases Firms Firms Firms Firms Warehouses
2067 37 39 2085 40 366 150 78 102 36 200 66 39 12
NN, logit Fuzzy rough-NN, Fuzzy-NN, crispNN Rough set CBR, logit PCA, MDA, logit, probit, IEWS (PCA + MDA + logit + Probit) MSD (LP + DA), DEA, C5.0 Loan classication model from OLS and MDA Rough set model using VCR BanXupport (IR + CBR) BPNN, logit RPA, DA Neuro-fuzzy and rough classiers Classical rough set and rough set with dominance relation Rough set approach with order domains
19851986 1988 19751994 19942001 19941996 19751976 19801990 19711981
1988 (continued on next page) 9
Table 3 (continued) Ref # [44] [45] Bank/rm Banks Firms Source of data/country of origin USA, (Federal Financial Institutions Examination Council Form 031)* Data used by Trippi and Turban [111]* #Samples 176 129 Techniques used Canonical correlation Ontogenic NN, DA, Odom & Sharda method, Back Propagation, Perceptron, Athena FILM, DA, ID3 DA, BPNN, CBR CBFS, DA, BPNN Mixed logit model, MNL Timeline of dataset 1987
10
[46] [47] [48] [51]
Several Firms Firms Firms
[52] [53] [54] [55] [57] [62] [63] [64] [65]
Banks Firms Firms Firms Banks Firms Firms Firms Firms
Data used by Liang [68]* Korea Korea Australia, [Aspect Financial Pty Ltds Financial Analysis Database, DatAnalysis Database, Huntleys Delisted Company Database, ASX market Comparative Analysis, Australian Securities and Investment Commission (ASIC)]* Taiwan Standard and Poors COMPUSTAT database* Finnish Finnish, Kera Ltd* USA Standard and Poors COMPUSTAT database* Standard and Poors COMPUSTAT database* Standard and Poors COMPUSTAT database* Korea, Korean Stock Exchange*
542 544 8241
19911993 19911993 19962003
24 50 1500 1137 8977 282 34 364 166
DA, BPNN MDA Euclidean-SOM, Fisher metric-SOM LDA, LVQ, SOM, RBF-SOM, KNN IEWS (using logit), IEWS (using Trait recognition) Cascor, DA FLDF, CBLP, MSD, LPC (combined method) BPNN MDA, ID3, MDA-assisted BPNN, ID3-assisted BPNN, SOFM-assisted BPNN BPNN, DA, SOM MDA, MDA with gray zone, NN (perceptron) Integration methods of DA, logit, Decision tree and BPNN Recursive partitioning, bootstrapping, polytomous probit Logistic regression
2000 19721976 19891992, 1 and 2 year 19701989 19851995 (1, 2 and 3) 19791992
[66] [67] [69] [70]
Firms Firms Firms Firms
South korea, Korean Investors Service (KIS)* Standard and Poors COMPUSTAT database* UK, London Stock Exchange* [Moodys Bond Record, Standard and Poors Stock Guide, CRSP tapes and Daily Stock Price Record]* USA, US commercial banks of Federal Reserve System*
168 88 1133 921
19951998 (2, 3) 1984 1988 (3) 19801999 (1)
[71]
Banks
5700
19701976
[73] [74] [75] [78] [79] [80]
Firms Firms Firms Firms Firms Firms
USA, Compact Disclosure* USA, Compact Disclosure* USA, Compact Disclosure* Greece Korea, Koreas largest credit guarantee organization* [1980 Bankruptcy Yearbook and Almanac, Lexis/Nexis Database, Standard & Poors COMPUSTAT database]* [Moodys Manual, Standard & Poors COMPUSTAT database, 10-k nancial statements]* Spanish South Korea, Industrial bank of Korea* [Bankruptcy Yearbook and Almanac, Lexis/ Nexis database]* 1. Belgian 2. Texas, Data used by Tam and Kiang [108]* 3. The data used by Rashad et al. [93]* Moody Industrial Manuals* Standard and Poors COMPUSTAT* Federal Home Loan Bank board quarterly tapes* Moodys Industrial Manuals* Moodys Industrial Manuals* South Korea USA Texas Texas UK DataStream and FT Excel company Research* Japan USA Italy German USA Moodys Industrial Manual*
200 291 291 110 1888 150
Rough set model, Recursive partitioning model Rough set, GA, Rough set + GA Rough sets, Auditor Fuzzy rule generator, LDA, QDA, logit, probit SVM, LDA, logit, BPNN ICPB-MSD, LDA, MSD, ICPB-GA and GA Logit
19861988 19911997 19911997 5 and 3 20002002 19871995, 3 years P. Ravi Kumar, V. Ravi / European Journal of Operational Research 180 (2007) 128
[83]
Firms
2163
19701976
[85] [86] [88] [89]
Banks Firms Firms Banks and Firms Firms Firms Firms Firms Firms Firms Banks Banks Banks Firms Firms Banks Firms Firms Banks Firms
66 2144 100 182 202 48
BPNN, logit, MARS, C4.5, DA AHP-CBR, logit-CBR, weightedKNN, Pure-KNN GA-based BPNN, BPNN BPNN with Feature construction (FC), BPNN without FC BPNN, Athena, Perceptron Isotonic separation, DA, LPD, BPNN, Rough sets and OC1 BPNN, logit SOFM, LDA, MLP, Perceptron, Athena. DA, BPNN, logit GA MDA, BPNN, Regulators BPNN, Factor logistic, DA, K-NN, ID3 LDA, logit, K-NN, ID3, feed forward NN, BPNN Quadratic interval logistic regression BPNN, DA GenSoFNN-CRI (S), MCMAC GA, LDA GANN, GA, BPNN FA + logit BPNN, DA
19971985 19951998 19891990 19871989 19851987 (1 and 2) 1980
[92] [97] [98] [100] [101] [102] [106] [107] [108] [112] [113] [124] [116] [118] [119] [121]
129 301 862 129 129 528 1741 188 202 904 114 3103 4738 6667 1900 129
19751982 19962001 (1, 2 and 3 years) 19861987 19751985 19751982 19951997 1993 19851987 (2 years) 19851987 19851994 (1 year) 19701991 19802000 19821995 19801982 19751982 (continued on next page)
11
12
Techniques used
PNN, PNN without pattern normalization, FDA, DA CBR (weighted NN, Pure NN), DA BPNN, Logistic Simple probit, bivariate probit and unweighted probit
solve classication problems. Each codebook vector is assigned to one of the target classes. Each class may have one or more codebook vectors. A case is classied by nding the nearest codebook vector and assigning the case to the class corresponding to the codebook vector (see comp.ai.neural-nets FAQ, Part 1 of 7: Introduction) [56]. Fahlman and Lebiere [28] introduced cascade correlation network, which adds units to the network during training. Such a network is trained for a while. Then, without altering the existing weights, one or more new hidden units are added to the network and then training resumes. The advantages of Cascor over backpropagation are: (1) automatic determination of a network topology resulting in good generalization (2) training time reduced by orders of magnitude and (3) the ability to rene an existing architecture to take into account new data without beginning the training process all over again [62]. 2.1.3. Decision trees Decision trees form a part of machine learning an important area of articial intelligence [33,91]. A majority of the decision tree algorithms are used for solving classication problems. However, algorithms like CART (classication and regression trees) can be used for solving regression problems also. All these algorithms induce a binary tree on the given training data, which in turn results in a set of ifthen rules. These rules can be used to solve the classication or regression problem. A number of algorithms are used for building decision tree including CHAID (Chi squared automatic interaction detection), CART, Quest and C5.0 [94]. 2.1.4. Rough sets Rough set theory proposed by Pawlak [87] is based on the assumption that with any object of the given universe there is some information associated and objects characterized by similar information are indistinguishable or indiscernible. The indiscernibility relation indicates that we are unable to deal with single objects but we have to consider clusters of indiscernible objects or equivalence classes of the indiscernibility relation. In rough set theory, a pair of precise concepts viz., lower and the upper approximations replaces any vague concept. Approximations are two basic operations in the rough set theory. Rough sets can be applied for inducing decision rules from data, to solve classication problems. The induced decision rules are categorized into exact and possible.
Timeline of dataset
19912001 1980 1991 19721978 Note: In the third column * indicates source of data and indicates that the data is not available. [123] [126] [128] Firms Firms Firms Australia, CD Financial Analysis* USA American and New York Stock Exchanges* 44 220 1681
#Samples Source of data/country of origin Table 3 (continued) Bank/rm Ref #
[122]
Firms
USA
122
19841989
13
2.1.5. Case-based reasoning Case-based reasoning (CBR), a branch of articial intelligence, is intuitively similar to the cognitive process humans follow in problem solving [58]. When people confront a new problem, they often depend on past similar experiences and reuse or modify solutions of these experiences to generate a possible answer for the problem at hand. The hallmark of CBR is its capability to give an explanation for its decision based on previous cases. Citing relevant previous experiences or cases is a way to justify a position [58] in human decision-making. Comprehensibility of the decision is often crucial in solving nancial problems. When a company is identied as failing, CBR can give examples of similar companies that failed in the past as a justication for its prediction. The heart of the CBR is the nearest neighbour algorithm [96]. 2.1.6. Support vector machines Support vector machines (SVM) introduced by Vapnik [115] use a linear model to implement nonlinear class boundaries by mapping input vectors nonlinearly into a high-dimensional feature space. In the new space, an optimal separating hyperplane (OSH) is constructed. The training examples that are closest to the maximum margin hyperplane are called support vectors. All other training examples are irrelevant for dening the binary class boundaries [22,115]. SVM is simple enough to be analyzed mathematically. In this sense, SVM may serve as a promising alternative combining the strengths of conventional statistical methods that are more theory-driven and easy to analyze and machine learning methods that are more data-driven, distribution-free and robust. Recently, the SVM has been used to nancial applications such as credit rating, time series prediction and insurance claim fraud detection. These studies reported that SVM was comparable to and even outperformed other classiers including BPNN, CBR, MDA and logit in terms of generalization performance. 2.1.7. Data envelopment analysis Data envelopment analysis (DEA) is a non-parametric performance assessment methodology introduced by Cooper et al. [21] to measure the relative eciencies of organizational or decision-making units (DMUs). The DEA applies linear programming to observing inputs consumed and outputs produced by decision-making units and constructs an ecient production frontier based on best
practices. Each DMUs eciency is then measured relative to this frontier. In other words, DEA assesses the eciency of each DMU relative to all the DMUs in the sample, including itself. This relative eciency is calculated by obtaining the ratio of the weighted sum of all outputs and the weighted sum of all inputs. The weights are selected so as to achieve Pareto optimality for each DMU. An appealing aspect of DEA is that it does not require price or cost data. Also, the DEA is invariant to scaling of variables. The DEA helps to identify inefcient DMUs as well and amounts of ineciency of inputs and/or outputs.
2.1.8. Soft computing The paradigm of soft computing or computational intelligence refers to the seamless integration of different, seemingly unrelated, intelligent technologies such as fuzzy logic, neural networks, genetic algorithms, machine learning (case-based reasoning and decision trees subsumed), rough set theory and probabilistic reasoning in various permutations and combinations to exploit their strengths. This term was coined by Zadeh [125] in the early 1990s to distinguish these technologies from the conventional hard computing that is inspired by the mathematical methodologies of the physical sciences and focused upon precision, certainty and rigor, leaving little room for modeling error, judgment, ambiguity, or compromise. In contrast, soft computing is driven by the idea that the gains achieved by precision and certainty are frequently not justied by their costs, whereas the inexact computation, heuristic reasoning and subjective decision making performed by human minds are adequate and sometimes superior for practical purposes in many contexts. Soft computing views the human mind as a role model and builds upon a mathematical formalization of the cognitive processes those humans take for granted [125]. Within the soft computing paradigm, the predominant reason for the hybridization of intelligent technologies is that they are found to be complementary rather than competitive in several aspects such as eciency, fault and imprecision tolerance and learning from example [125]. Further, the resulting hybrid architectures tend to minimize the disadvantages of the individual technologies while maximizing their advantages. Some of the soft computing architectures employed are neurofuzzy, fuzzyneural, neurogenetic, geneticfuzzy, neurofuzzygenetic, roughneuro,
14
etc. Multi-classication systems or ensemble classiers are also treated as soft computing systems. 3. Statistical techniques Altman et al. [5] developed a new bankruptcy classication model called Zeta analysis, which incorporated comprehensive inputs. The data sample consists of 111 rms with seven variables each. They found that the ZETA model outperformed alternative methods in terms of expected cost criteria. Classication accuracy of this model ranged from 96% for one period prior to bankruptcy to 70% for ve periods prior to bankruptcy. Martin [71] presented logistic regression to predict probability of failure of banks based on the data obtained from the Federal Reserve System, data sample. Ohlson [83] employed the logit model to predict rm failure. The data was obtained from Moodys Manual, Compustat data tapes and 10K nancial statements. The classication accuracy reported by him was 96.12%, 95.55% and 92.84% for prediction within one year, two years and one or two years respectively. Dietrich and Kaplan [24] developed a simple three-variable linear model to classify loan risks. He compared his model with (i) Altman model and (ii) Wilcox bankruptcy prediction [120] model and got better performance over them. They used six independent variables and one dependent variable suggested by individual experts. The model gave better accuracy than previous bankruptcy models in predicting the riskiness of loan. Zmijewski [128] examined two estimation biases for nancial distress models on non-random samples. The rst bias results from oversampling distressed rms and falls under the topic of choicebased sample biases. The second results from using a complete data sample selection criterion and falls under the topic of sample selection biases. The data used in the study was obtained from the American and New York Stock Exchanges. The data set consisted of estimation sample of 40 bankrupt and 800 non-bankrupt rms and a prediction sample of 41 bankrupt and 800 non-bankrupt rms. The choice-based sample was examined using unweighted probit and weighted exogenous sample maximum likelihood. The sample selection bias issue was examined using simple probit and bivariate probit assessment. West [119] used the factor analysis to create composite variables to describe banks nancial and operating characteristics. Data
was taken from Call & Income reports and examination reports for 1900 commercial banks in some states of USA. He demonstrated that his combined method of factor analysis and logit estimation was promising in evaluating banks condition. Karels and Prakash [53] conducted a study in a threefold manner; (i) Investigated the normality condition of nancial ratios required by the MDA technique; (ii) when these ratios are non-normal, they constructed ratios which are either multivariate normal or almost normal; (iii) using these ratios to compare the prediction results of DA with that of other studies. They used a random sample of 50 companies obtained from the COMPUSTAT data tapes. They reported 96% classication rate for non-bankrupt rms and 54.5% for bankrupt rms. Haslem et al. [44] determined the implication of the foreign and domestic strategies reected in the balance sheets of US commercial banks. Also, they determined the impact of strategies on the protability performance. For the analysis, they used the 1987 balance sheet data from the call reports of 176 large US banks having both foreign and domestic oces. They used canonical correlation analysis to analyze balance sheet for the large and very large bank samples and generated canonical variate scores. Kolari et al. [57] developed early warning system (EWS) based on logit analysis and Trait recognition for large US banks. The logit model correctly classied over 96% of the banks 1 year prior to failure and 95% of the banks 2 year prior to failure. For developing trait recognition model, they used half of the original sample. Because of this reduction in the sample size it has disadvantages over logit model. In both 1 year and 2 year prior to failure data classication accuracy of trait model was 100%. It was concluded that trait recognition outperformed logit model in terms of type-I and type-II errors. Recently, Jones and Hensher [51] presented mixed logit model for rm distress prediction and compared it with multinomial logit models (MNL). They modeled nancial distress problem in three states viz., state 0: non-failed rms; state 1: insolvent rms, state 2: rms which led for bankruptcy. They developed two samples for model estimation and validation. The results are too detailed to present here. They concluded that mixed logit obtained substantially better predictive accuracy than multinomial logit models. Canbas et al. [18] proposed an integrated early warning system (IEWS) by combining DA, logistic regression, pro-
15
bit and principal component analysis (PCA), that helped in examination and detection of banks with serious problems. PCA explored three nancial components, which signicantly explained the changes in the nancial condition of banks. With these three factors they employed DA, logistic regression and probit models. Then, by combining all these together they constructed an IEWS. They used the data of Turkish banks available in website (http://www.tbb.org.tr/english/bulten/yillik/2000/ ratios.xls). The results are too elaborate to present here. They concluded that IEWS has more predictive ability than other models. 4. Neural networks This section reviews the papers where dierent topologies of neural networks (NN) are proposed and compared with other techniques. This section is split into three sub sections covering the applications of (i) back propagation trained NN (BPNN), (ii) self-organizing feature map (SOM) and (iii) other NN topologies such as probabilistic NN, auto associative NN and cascade correlation NN. 4.1. Back propagation trained neural network (BPNN) Tam [107] employed BPNN for bankruptcy prediction. Data were obtained from Texas banks, one year and two years prior to failure. He selected the variables based on CAMEL criteria of FDIC. He showed that BPNN oered better predictive accuracy than other methods viz., DA, factor-logistic, K-nearest neighbour (K-NN) and ID3 [77]. Tam and Kiang [108] compared the performance of (i) LDA, (ii) logistic regression, (iii) K-NN, (iv) ID3, (v) feedforward NN (net0) and (vi) BPNN (net10) on bankruptcy prediction problems. BPNN outperformed other techniques for one-year prior training sample, whereas for two-year prior training sample DA outperformed others. However, BPNN outperformed others in both the one-year prior and the two-year prior holdout samples. In jackknife method [61] also, BPNN outperformed others in both the one-year prior and the two-year prior holdout samples. So, with the evidence of jackknife method, they concluded that NN outperformed the DA methods. Salchenberger et al. [98] presented a BPNN to predict the probability of failure for savings and loan associations (S&Ls). They compared its
performance with a logistic model. They considered 29 variables from the CAMEL categories and performed stepwise regression that identied ve variables. Results are too detailed to present here. They concluded that BPNN outperformed logistic regression. Sharda and Wilson [101] compared the BPNN with MDA based on resampling technique. They used Altmans ve variables. They used BPNN with ve input nodes, 10 hidden nodes and two output nodes. They concluded that BPNN outperformed DA in all cases. Fletcher and Goss [29] used the BPNN for predicting bankruptcy of rms and compared it with logistic regression. They employed v-fold cross-validation technique. The data of 36 companies was drawn from Gentry et al. [34]. They used three independent variables. BPNN prediction performance was 82.4% whereas logistic regression produced only 77%. Altman et al. [4] compared the performance of LDA with BPNN in distress classication. They used 10 nancial ratios. The data sample consisted of three types of rms viz., (i) healthy, (ii) unsound and (iii) vulnerable. Three sample data sets were used for this study. They obtained best results with BPNN having three layers: initial hidden layer of 10 neurons, second hidden layer with four neurons and an output layer of one neuron. They concluded that LDA marginally outperformed BPNN. Wilson and Sharda [121] compared the predictive accuracy of BPNN with that of DA. They used Altman [3] variables. They concluded that BPNN outperformed other methods over all test samples. Tsukuda and Baba [113] performed the prediction of bankruptcy using BPNN with one hidden layer and concluded that BPNN outperformed the DA. Leshno and Spector [67] compared various NN models and DA and explained their prediction capabilities in terms of data span, learning technique and number of iterations. This study used the perceptron like network for input features of two types viz., (i) functional expansion (FE), (ii) joint activation (JA) and investigated their eect on generalization. They used 41 nancial ratios including Altman [3] variables. They concluded that NN outperformed the Z-score model. Rahimian et al. [92] compared the performance of (i) BPNN, (ii) Athena, an entropy-based neural network and (iii) single layer perceptron on the bankruptcy prediction problem. They compared them with Odom and Shardas [82] BPNN and discriminant analysis also. The accuracies obtained on the test data were (i) discriminant analysis produced 74.54%, (ii)
16
Odom and Shardas test produced 81.81%, (iii) Athena yeilded 81.81%, (iv) perceptron yielded 81.81% and (v) BPNN produced 81.81%. The BPNN implemented in this study outperformed Odom and Shardas [82] BPNN in terms of speed. Barniv et al. [11] compared BPNN, multi-state ordered logit and non-parametric multiple discriminant analysis (NPDA). They developed a model for classifying rms into three states viz. acquired, emerging and liquidated. They designed two models viz., (i) twelve variable model and (ii) ve variable model. These two models outperformed Ohlsons [83] nine variable model. They concluded that BPNN outperformed NPDA and logit models. Bell [12] compared logistic regression and BPNN in predicting bank failures. In this study, he used 28 candidate predictor variables. The architecture of BPNN was 12 input nodes, six hidden nodes and one output node. He concluded that neither the logit nor the BPNN model dominated the other in terms of predictive ability. But, for complex decision processes BPNN was found to be better. Piramuthu et al. [89] designed a method called feature construction (FC) and used it with BPNN for bankruptcy prediction. They used the Belgian Bankruptcy data of 182 banks, Tam and Kiang [108] data and Rashid and EI-Sheshai [93] data of 48 banks. They concluded that BPNN with FC outperformed the plain BPNN in all datasets. Zhang et al. [126] used generalized reducing gradient (GRG2) trained three-layered NN for bankruptcy prediction. They used v-fold cross-validation technique for testing. They reported that overall classication rates of GRG2 trained NN ranged from 77.27% to 84.09% whereas that for logistic regression ranged from 75% to 81.82%. They concluded that GRG2 trained NN outperformed logistic regression. Atiya [7] reviewed the applications of NN in bankruptcy prediction and developed an NN. He developed novel indicators for the NN, taking cue from Merton [76]. For the study he collected data from defaulted and solvent US rms. He reported a prediction accuracy of 84.52% for the in-sample set and 81.46% for the out-of-sample set. He showed that the use of the indicators in addition to nancial ratios provided signicant improvement. Swicegood and Clark [106] compared DA, BPNN and human judgment in predicting bank failures. The variables were taken from the bank call reports. Overall, MDA model correctly classied 86.4% and 79.5% of regional and community banks
respectively. However, BPNN model correctly classied 81.4% and 78.25% of regional and community banks. They concluded that BPNN outperformed other two models in identifying under performance banks. Lam [64] integrated fundamental and technical analysis in BPNN for nancial performance prediction. The predictors included 16 nancial and 11 macroeconomic variables. She concluded that BPNN signicantly outperformed the minimum benchmark based on highly diversied investment strategy. Also, incorporation of previous years nancial data in the input vector for BPNN could signicantly increase the return level, thereby, demonstrating the benets of integrating fundamental analysis with technical analysis via BPNN. She also extracted rules from trained neural network and found that they outperformed the neural networks per se. Further, they performed as accurately as the maximum benchmark. Lee et al. [66] compared BPNN with self-organizing feature map (SOM), DA and logistic regressions. The data sample consisted of 168 Korean rms taken from the Security and Exchange Commission (SEC) lings stored in an on-line database of the Korea Investors Service (KIS) Inc. (www.kisrating.com). The fourfold cross-validation testing was used for all the models. The results are too detailed to present here. They concluded that the BPNN outperformed the all other techniques. 4.2. Self-organizing maps (SOM) Lee et al. [65] proposed three hybrid BPNN viz., (i) MDA-assisted BPNN (ii) ID3-assisted BPNN and (iii) SOM-assisted BPNN for predicting bankruptcy in rms. The data of 166 rms is taken from the Korea Stock exchange. They selected 57 nancial variables. They concluded that hybrid neural network models performed better than MDA and ID3. Serrano-Cinca [100] compared the performance of SOM with LDA and BPNN in nancial diagnosis. The data set consisted of Altmans [3] variables. The architecture of SOM used was 4 input nodes and 144 output nodes arranged in a 12 12 square grid in order to accommodate 74 patterns in data sample. He proposed two hybrid neural systems viz., (i) a combination of LDA with SOM, where LDA calculated the Z-score for each rm, which was superimposed onto SOM to obtain isosolvent regions, (ii) a combination of BPNN with SOM. The LDA obtained 74.5%, while other models such as Rahimian et al.s MLP [92], Odom and
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Shardas MLP [82], Perceptron model, Athena Model and his own MLP obtained 81.8%. The proposed system outscored Z-score analysis in providing intuitive visual graphics that give information on the risk of bankruptcy, the nancial characteristics of rm and that type of rm it is similar to. Kiviluoto [55] used SOM and proposed its variants for rm bankruptcy prediction. He compared three dierent SOM-based classiers viz., SOM-1, SOM-2 and RBF-SOM hybrid with LDA, learning vector quantization (LVQ) and K-NN. The parameters for each classier were determined using v-fold cross-validation technique. He modied the LVQ algorithm to accommodate the NeymanPearson classication criteria. This NeymanPearson LVQ not only speeded up the convergence but also increased the classication accuracy. He used the data segment from Kera Ltds customer companies for the study. He concluded that NeymanPearson LVQ is more useful than one minimizing the total number of misclassications. He concluded that other classiers outperformed SOM-1. He also concluded that RBF-SOM performed slightly better than other classiers. Kaski et al. [54] introduced Fisher information matrix based metric and implemented SOM with it. They used the new method to understand the non-linear dependencies between bankruptcies and nancial indicators. The dependencies were converted into a metric of the input space and the SOM was used to visualize the dependencies in a concise form. They obtained 23 nancial indicators from Finnish small and medium-sized enterprises. They computed the accuracy of SOMs in the Euclidean metric (SOM-E) and in the Fisher metric (SOM-F) in representing the probability of bankruptcy, measured by the likelihood of data at the location of the best matching SOM units. He concluded that the SOM-F performed better than the SOM-E. 4.3. Other neural network topologies Lacher et al. [62] proposed a cascade-correlation neural network (Cascor) for classifying nancial health of a rm. Altmans ve nancial ratios were used. Data was collected from Standard and Poors COMPUSTAT nancial database. He compared the performance of the Cascor model with that of Altman Z-score model. They concluded that the Cascor model consistently yielded higher overall classication rates. Yang et al. [122] proposed PNN without pattern normalization and Fisher
discriminant analysis (FDA) to solve bankruptcy prediction problem. They compared the original PNN and PNN without pattern normalization (PNN*) and FDA with DA and BPNN. The Data used was taken from Platt et al. [90]. The rst four ratios were deated to remove the dierences in ratio values over time caused by uctuations in related factors. The results are too detailed to present here. They concluded that the PNN* and BPNN with non-deated data achieved better classication rates. FDA produced better classication results with deated data. They found that deation improved the discrimination ability of some of the prediction models as observed in [90]. Baek and Cho [9] proposed the auto-associative neural network (AANN) for Korean rm bankruptcy prediction. They trained the AANN with only solvent rms data. Then they applied the test data containing both solvent and insolvent rms. So, any solvent rm data that shared common characteristics with the training data resulted in small error at the output layer while the bankrupt rms data resulted in a large error at the output layer. AANN yielded classication rates of 80.45% for solvent and 50.6% for defaulted rms. However, the 2-class BPNN produced classication rates of 79.26% for solvent and 24.1% for defaulted rms. Therefore, they concluded that AANN outperformed 2-class BPNN. 5. Case-based reasoning techniques Bryant [16] designed a CBR system for bankruptcy prediction. He compared it with Ohlsons [83] logit model. CBR cluster trees were created with three case libraries viz., model-I, model-II and model-III. They consisted of 25 nancial variables for one year, two year and three years data. The results reported by him are too elaborate to mention here. He concluded that logit outperformed CBR in terms of less Type-I accuracy. Jo et al. [47] used MDA, CBR and BPNN to predict bankruptcy. They considered the data taken from Korean rms. Variables were selected using the dimension reduction techniques such as stepwise selection and t-test. The average hit ratio of DA, BPNN and CBR was 82.22%, 83.79% and 81.52%, respectively. They concluded that BPNN outperformed DA and CBR and DA outperformed CBR. Park and Han [86] proposed analytic reasoning model called the K-NN with analytic hierarchy process (AHP) feature weight approach for bankruptcy prediction. They
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proposed CBR for indexing and retrieving similar cases. The AHP-weighted K-NN was compared with pure K-NN algorithm. For this study, they used the data obtained from Industrial Bank of Korea. They used both nancial and non-nancial variables. The classication accuracy of pure KNN approach was 68.3% whereas the hybrids Logit-CBR and AHP-K-NN-CBR produced 79.2% and 83.0%, respectively. They concluded that weighted K-NN hybrid model outperformed other models. Yip [123] used CBR with K-NN to predict Australian rm business failure. She used the statistical evaluations for assigning the relevancy of attributes in the retrieval phase of algorithm. She compared the performance of CBR + K-NN with that of DA. The overall accuracy of CBR with weighted K-NN, CBR with pure K-NN and DA were 90.9%, 79.5% and 86.4%, respectively. She concluded that CBR with weighted K-NN was better than DA. 6. Decision trees In this section, we review the works reported on the application of decision trees. Decision trees use recursive partitioning algorithm to induce rules on a given data set. Marais et al. [70] proposed recursive partitioning algorithm (RPA) for predicting bankruptcy in rms. They used (i) recursive partitioning technique and (ii) bootstrapping. They applied polytomous probit and recursive partitioning to the data sample. The results reported are too detailed results to be presented here. However, it can be inferred that when all the variables were used, polytomous probit outperformed recursive partitioning in terms of expected misclassication rates in both resubstitution and bootstrap methods. Frydman et al. [31] presented the application of RPA to bankruptcy prediction and compared it with the DA and the analysis was carried out for misclassication cost of C12 ranging from 1 to 70, where C12 denotes the cost of misclassifying sample belonging to group 1 to group 2. They constructed two variants of discriminant functions viz., DA1 and DA2 and compared them with two RPA models viz., (i) RPA1 with relatively complex tree and (ii) RPA2 with smallest v-fold cross-validation risk. RPA1 model outperformed DA1 and DA2 models for all costs. Also, RPA2 tree turned out to be sub tree of RPA1 tree for every cost. They showed that RPA2 had larger resubstitution risk.
7. Evolutionary approaches Varetto [116] employed a genetic algorithm (GA) for bankruptcy prediction and compared its performance with that of LDA. He conducted the study for: (i) one year prior to bankruptcy data and (ii) three years prior to bankruptcy data. He reported that for case (i), the genetic linear function yielded 92% classication rate for bankrupt companies and LDA yielded 90.1%. However, in case (ii), he observed that LDA outperformed the genetic linear function in the case of sound companies. He also inferred that the LDA has a higher stability and generalization power. Nanda and Pendharkar [80] incorporated misclassication cost matrix into an evolutionary classication system. Using simulated and real-life bankruptcy data, they compared the proposed method with LDA, a goal programming and a GA-based classication without the asymmetric misclassication costs. For bankruptcy training set the classication accuracy of integrated cost preference based mininized sum of deviations (ICPBMSD) and integrated cost preference based GA (ICPB-GA) outperformed LDA, MSD and GA. For simulated holdout set the ICPB-GA outperformed others. They concluded that the ICPBMSD or ICPB-GA might be promising when compared to traditional MSD or GA. Shin and Lee [102] also proposed a GA-based approach for bankruptcy prediction. The rules generated by GA were easily understood and could be used as expert systems. Data used contained 528 rms. The ve rules generated by GA got 80.8% accuracy. They concluded that GA could successfully learn linear relationship among input variables. 8. Operational research Banks and Prakash [10] proposed the linear programming heuristic to a quadratic transformation of data to predict rm bankruptcy prediction. Quadratic discriminant function (QDF) got three misclassications whereas Johnson and Wichern [50] got 46. They concluded that the quadratic transformation method outperformed the QDF. Lam and Moy [63] compared dierent DA methods and proposed the their combination to predict the classication of new observations. For testing this hybrid technique, they used simulation experiment. Discriminant analyses taken for this study were FLDF (Fisher linear discriminant analysis), cluster-based LP (CBLP) and MSD (minimized sum of devia-
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tions). Their simulation generated data from contaminated multivariate normal distribution for the rst 24 cases and for remaining 10 cases contained non-contaminated data to test the robustness of LPC, which combined classication results of dierent DA. Their combined method outperformed other DA methods. LPC was reformulated as a mixed-integer programming model, which minimized weighted number of misclassications. Cielen et al. [19] compared the performance of minimized sum of deviations (MSD), data envelopment analysis (DEA) model and a rule induction (C5.0) model on bankruptcy prediction problem. Here MSD was a combination of linear programming (LP) and DA. The dataset was taken from National Bank of Belgium. The MSD, DEA and C5.0, obtained classication rates of 78.9%, 86.4% and 85.5% respectively. They concluded that DEA outperformed C5.0 and MSD model. Kao and Liu [52] formulated a DEA model for interval data for evaluating the performance of banks. This study made advance predictions of the performance of 24 Taiwan banks based on uncertain nancial data presented in ranges. They presented the prediction of eciency scores also in ranges. Among 24 banks, two banks got the smallest predictive eciency scores of 0.7358 and 0.7584 because these two banks suered from Asian nancial crisis and had many bad debts. They showed that DEA predicted the bank performance based on their nancial forecasts. 9. Rough sets Greco et al. [38] proposed a new rough set approach for solving bankruptcy prediction problem considering the criteria of attributes with ordered domains. This approach was similar to the original rough set analysis in that it used the approximation of partitioning the objects in some pre-dened category. However, it employed both dominance relation and indiscernibility relation. They represented warehouse making loss with class CL1 and warehouse making prot with class CL2. The classical rough set approach got the accuracy of approximation of 0.6 and 0.7 for CL1 and CL2 respectively and the quality of classication was 0.83. However, the proposed approach got the accuracy of approximation of 0.33 and 0.6 for CL1 and CL2 respectively and the quality of classication was 0.67. They concluded that the proposed approach showed improvements over the original rough set analysis. This improvement be seen by
the smaller reduct of {A1, A4} obtained by the proposed approach as against the reduct {A1, A2, A3 and A4} obtained by original rough set analysis obtained. The decision rules obtained from the proposed approach gave more synthetic representation of knowledge contained in the information. Greco et al. [37] presented a new rough set method based on approximation of a given partition of set of rms into pre-dened and ordered categories of risk by means of dominance relation in place of indiscernibility relation for the evaluation of bankruptcy in rms. Dominance relation was proposed in place of indiscernibility relation in [3943,103]. The classical approach based on indiscernibility relation is applied to classication problems with regular attributes and preferentially non-ordered decision classes, whereas, the dominance-based rough set approach handles preference-ordered domains of attributes (criteria) and preference-ordered decision classes. The dominance-based rough set approach performs very well on nancial data. It is also the only data mining approach handling preference order in data. The data set was obtained from Greek industrial development bank (ETEVA). The data sample was classied into (i) unacceptable, (ii) uncertainty and (iii) acceptable. They compared classical rough set with their proposed method. They showed that the proposed method gave smaller number of reducts than classical rough set approach based on indiscernibility. The quality of the approximation obtained by classical rough set approach and the proposed method based on dominance were 1 and 0.949 respectively. Also, the decision rules obtained from the approximation by dominance relation gave a more synthetic representation of information contained in decision tables. They showed that rules based on dominance relation are better to sort new actions than the rules based on indescernibility relation. Dimitras et al. [26] also used rough set theory for predicting business failures. They used VCR (valued closeness relation), which prevents major dierences on one attribute from being compensated by number of minor dierences on other attributes. They used the data collected from large number of Greek rms. VCR nearest rules correctly classied 60% of banks not classied by exactly matching rules. They compared the accuracy of rough set based approach with DA and logit and concluded that the rough set approach outperformed the other two in revealing the relevant attributes in evaluating the rm failure risk. McKee [73]
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developed a rough set based bankruptcy prediction model. Rough set analysis produced better results when the attribute domains for continuous variables were nite sets of low cardinality. Here, the variables identied by recursive partitioning method were used to develop rough set based model which yielded 88% accuracy in predicting bankruptcy on a 100-company holdout sample. This was superior to the original recursive partitioning model, which was only 65% accurate on the same data set. Bioch and Popova [14] proposed a modication of the rough set approach for bankruptcy prediction. They used monotone extensions, decision lists and dualizations to compute classication rules that cover the whole space. The dataset used here were taken from [105]. They computed the monotone decision trees for the dataset. They concluded that there was close relationship between the decision rules obtained using the rough set approach and the prime implicants of the maximal extension. McKee [75] compared rough set prediction capability with actual auditor signaling rates for US companies. He developed two dierent models with four variables from the 11 possible variables. These two models achieved classication accuracy of 61% and 68% on the validation set. Auditors achieved classication accuracy of 66%. The model accuracy rate in this study was signicantly lower than the one reported in previous studies employing both rough sets theory and other methods. This was because the samples employed here were more realistic than prior studies. 10. Other techniques In this section, the papers applying fuzzy techniques, SVM and isotonic separation are reviewed. Since these techniques found relatively fewer applications in bankruptcy prediction, all of them are grouped under this category. Michael et al. [78] proposed fuzzy rule generator method for bankruptcy prediction and compared it with LDA, QDA, logit analysis and probit analysis. They used two samples of data from Greek rms. Fuzzy rule based classier got 7.48% of type-I error, 44.83% of type-II error and overall error was 26.16%. The overall classication error of LDA, logit and probit analysis was 29.35%, 27.15% and 30.63%, respectively. They concluded that fuzzy rule based classier outperformed other methods. Alam et al. [2] proposed fuzzy clustering for identifying potentially failed banks and then compared it with two SOM networks viz., (i)
competitive neural network and (ii) SOM. The results are too detailed to be reported here. They concluded that both fuzzy clustering and SOM are good tools in identifying potentially failing banks. Andres et al. [6] proposed fuzzy rule based classiers for bankruptcy prediction problem. They compared the performance of LDA and logistic regression with multi-layer perceptron and fuzzy-rule based classiers. They also used Monte Carlo simulation to measure the eects of sample size variations on the performance of classiers. The distinctive features of this study were: (i) for each classier and a wide range of sample sizes, average error rates were estimated from the results of a large number of Monte Carlo simulations. (ii) The focus was on business protability analysis, which was not considered earlier. (iii) Their classication problem had a low separability degree. (iv) A slight variant of the class of additive fuzzy systems with Gaussian membership functions and consequent normalized to be probabilities was tested. They used the database of commercial and industrial rms located in Spain. The results are too elaborate to present here. They concluded that MLP and fuzzy rule based classier outperformed LDA and logistic regression. Min and Lee [79] proposed SVM [115] for bankruptcy prediction. He proposed grid-search technique using vefold cross validation to nd out the optimal parameter values of kernel function of SVM. He compared the SVM with MDA, Logit and BPNN. He used two kernels for SVM viz., (i) RBF kernel and (ii) polynomial kernel. The classication rates of MDA, logit, BPNN and SVM for training data were 78.80%, 79.86%, 85.24% and 88.01%, respectively and for holdout data 79.13%, 78.30%, 82.53% and 83.06%, respectively. They concluded that the SVM outperformed BPNN, MDA and logit models for the training and holdout data. Ryu and Yue [97] introduced isotonic separation for prediction of rm bankruptcy. They compared isotonic separation with (i) DA, (ii) linear programming discrimination (LPD), (iii) BPNN, (iv) LVQ, (v) rough set analysis and (vi) oblique decision tree method (OC1). They used three feature selection methods viz., (i) backward sequential elimination (BSE) method with isotonic separation and LP, (ii) stepwise discriminant analysis (SDA) method with DA and (iii) mutual information-based (MIB) method with BPNN. They employed 10-fold cross validation for testing their method. They concluded that the rough set method was the top performer followed by OC1 and LVQ. BPNN,
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logistic discrimination and probit methods performed worse than others. Results are too detailed to present here. They concluded that isotonic separation outperfomed other methods for short-term bankruptcy prediction. 11. Soft computing techniques In this section, papers employing various hybrid intelligent techniques to solve bankruptcy prediction problem are reviewed. These papers developed new hybrid systems combining the intelligent techniques and sometimes some proven statistical models. Three varieties of soft computing architectures have been employed so far: (i) ensemble classier [96], where techniques such as BPNN, DA, logistic regression, MARS, C4.5, fuzzy logic, rough set based approach, GA, GP were employed to solve the problem in a stand-alone mode and then their results are combined through an arbitrator which performs simple majority voting or weighted majority voting schemes or a linear combination of predictions; (ii) an intelligent technique is used for feature selection task and another intelligent technique performs classication by taking the selected features and (iii) tightly integrated hybrid systems such as GA trained NN, neuro-fuzzy, GA-neurofuzzy, etc. The papers reviewed in this section employed one of these three architectures. Back et al. [8] developed a hybrid architecture where LDA, logit and GA take care of feature selection and the selected features were used as predictors for BPNN in bankruptcy prediction. The data consisted of the annual nancial statements of Finnish companies. They employed ve hybrid models viz., (i) DA used for feature selection + DA used for prediction, (ii) logit used for feature selection + logit used for prediction, (iii) DA used for feature selection + BPNN used for prediction, (iv) logit used for feature selection + BPNN used for prediction and (v) GA used for feature selection + BPNN used for prediction. They concluded that BPNN and model (v) got improved results than models (iii) and (iv). Ignizio and Soltys [45] presented a GA-based approach for the simultaneous design and training of neural networks for rm failure prediction. They called hybrid neural network as ontogenic NN. The data taken from [92] consisted of ve variables. They inferred that the hybrid obtained less number of misclassied cases compared to other methods. Wallrafen et al. [118] studied the Genetic algorithm-neural network hybrid
(GANN), where dierent parameters of NN such as topology, connection weights and input variables selection were encoded. They used the data of German corporations. The performance of GANN was compared on the basis of the Type-II error, while the costlier Type-I error was kept constant. Using all input variables, BPNN achieved a Type-II error of 44.2% on the test sample. The genetic algorithm reduced the Type-II error from 42.6% to 36.1%. Optimized GANN achieved Type-II error of 46.6% on validation set due to over selection eect. Optimized neural network did not outperform earlier solutions on the validation set. Jo and Han [48] designed a new architecture by hybridizing case-based forecasting (CBFS), BPNN and DA, which achieved higher prediction accuracy than these individual models operated in standalone mode. Three types of data viz., training, testing and generalization, collected from Korean companies, were used. The proposed hybrid intelligent system comprised a linear combination of the following ve models viz., (i) DA, (ii) BPNN1 (which is BPNN with one hidden layer), (iii) BPNN2 (which is BPNN with two hidden layers), (iv) CBFS1 (which uses a similarity measure to determine the number of base cases) and (v) CBFS2 (which uses all the base cases). They performed numerical experiments with dierent weights for the ve models. The best combination of weights was found to be (2, 3, 5, 1 and 4) with prediction accuracy of 90.78% for data set-I and (1, 5, 4, 2 and 3) with prediction accuracy of 89.72% for data set-II. Hit ratio of integrated model using equal weights for the output of the ve models was 89.36%. Jeng et al. [46] presented a fuzzy inductive learning method (FILM) that integrated fuzzy set theory with regular inductive learning process for prediction. They compared the FILM with DA and ID3. Bankruptcy dataset was taken from [68]. The prediction accuracy of FILM, DA and ID3 was 83.3%, 76.7% and 70%, respectively. Thus they concluded that FILM outperformed both DA and ID3 in the case of bankruptcy data. Olmeda and Fernandez [85] compared the accuracy of classiers in stand-alone mode, on bankruptcy prediction problem. They also developed a hybrid system integrating them. They proposed a framework to formulate the choice of the optimal mixture of the technologies as an optimization problem and solved it using a genetic algorithm. For the optimal structure, they used v-fold cross-validation technique.
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Data for this study was obtained from Spanish banking system. For the models combined by a compensating aggregation method they employed the dataset used in Odom and Sharda [82]. BPNN performed the best followed by logit, MARS, C4.5 and DA in that order. They combined models in two ways: (i) by simple voting scheme and (ii) by a compensation aggregation method. Overall prediction rates yielded by combined models viz., NN + logit + C4.5 + DA, NN + logit + C4.5, NN + logit + MARS + DA, NN + logit, NN + logit + C4.5 + MARS, NN + logit + DA, NN, all methods and NN + logit + MARS by simple voting scheme were 96.21%, 94.94%, 94.69%, 93.93%, 93.18%, 92.42%, 92.42%, 91.66% and 90.91%, respectively. They suggested that BPNN model was superior to both classical and new statistical and machine learning classiers. They found that hybrid methods by simple voting gave more accurate predictions than the stand-alone methods. Gorzalczany and Piasta [36] presented two dierent hybrid intelligent decision support systems viz., (i) neuro-fuzzy classier (N-FC) and (ii) rough classier (RC) for rm bankruptcy prediction. RC was a combination of rough set based rule induction system and statistical techniques. They used Altmans [3] data in this study. Leave-one-out method was employed to test the models. Classication accuracies of N-FC (with 10 hidden nodes), RC (generated by ProbRough), C4.5 and CN2 on corporate bankruptcy data were 97%, 90.4%, 84.8% and 86.4%, respectively. They concluded that N-FC outperformed other techniques. Elhadi [27] presented a hybrid system integrating information retrieval (IR) and CBR for legal domain of bankruptcy law. He designed an IR-CBR bankruptcy support system (BanXupport). Each case was related to a bankruptcy law section. BanXupport currently had three clusters corresponding to the three most important sub-sections viz., Stay, exemption and preferences. Knowledge in the system was represented in two ways: IR based and CBR based. Validation of the system was done in two ways: rst check the ability of the IR components in selecting categories and then check the ability of the CBR system in selecting the most similar instances. The overall accuracy by TDV (term discrimination values) an SS (statue-seeded automatic indexing and retrieval approach) based on 71-case set was 85% and 95%, respectively. When using the textbook set of 31 cases on the SS component, the system could correctly classify 87% of cases. He ran rst
set of 71-cases on the CBR component of the system after being pre-classied using SS. Classication values ranged from 16% to 97% for exemption, 40% to 93% for preference and 15 to 93% for stay. They showed that BanXupport matched cases based on the selected terms and provided a numerical measure to test the level of similarity to each section. They concluded that the BanXupport suggested relevant cases with a similarity measure. Ahn et al. [1] proposed hybrid models combining rough sets and BPNN for Korean rm failure prediction and compared it with stand-alone BPNN and DA. They used (i) BPNN (ii) BPNN trained with horizontally reduced information system (RNN1) meaning that the feature selection was performed before training the NN and (iii) BPNN trained with horizontally and vertically reduced information system (RNN2) meaning that feature selection and sample size reduction were carried out before training NN. The architecture chosen for BPNN was eight input nodes, ve hidden nodes and one output node (reported as 8-5-1), while for RNN1 and RNN2 4-3-1 architecture was used. They employed 12-fold cross-validation technique in testing phase. They constructed two hybrid models (i) hybrid model I combining rough sets with RNN1, (ii) hybrid model II combining rough sets with RNN2. The average prediction accuracy of DA, BPNN, RNN1, RNN2, Hybrid I and Hybrid II were 78.75%, 84.62%, 89.5%, 89.79%, 94.3% and 94.34%, respectively. They inferred that hybrid models I and II outperformed both BPNN and DA. Lin and McClean [69] developed hybrid models integrating BPNN, a decision tree (C5.0), DA and logistic regression in dierent combinations for predicting corporate failures in UK. They selected the variables using two feature selection methods viz., (i) nancial theory and human judgment (ii) ANOVA. They compared the performance of DA, logistic regression, C5.0 and BPNN. Prediction accuracy of DA using rst feature selection method was 78.6%, whereas DA with second feature selection method produced 77.4%. Prediction accuracy of logistic regression using rst feature selection method was 84%, whereas logistic regression using second feature selection method yielded 84.6%. Prediction accuracy of BPNN using rst feature selection method was 87.5%, whereas using BPNN with second feature selection method yielded 88.1%. They also proposed some other hybrid models viz., (i) Hybrid 1 DA + logistic regres-
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sion + NN + C5.0, (ii) Hybrid 2 DA + NN + C5.0, (iii) Hybrid 3 logistic regression + C5.0. Using the rst feature selection method the prediction accuracy of Hybrids 1, 2 and 3 was 88.4%, 88.1% and 88.1%, respectively. However, using second feature selection method the prediction accuracy of Hybrids 1, 2 and 3 was 89.6%, 89.6% and 89.3%. They concluded that ANOVA performed better than human judgment except for DA and that the BPNN and C5.0 outperformed statistical approaches. They also concluded that hybrid model produced better results. McKee and Lensberg [74] presented a hybrid approach to bankruptcy prediction by integrating a rough set model with genetic programming (GP). They suggested a two-stage hybrid model: stage 1 used a rough set model in Ref. [74] to identify subsets of important explanatory variables and stage 2 comprised a GP algorithm in Ref. [59] to develop a structural model of bankruptcy based on those variables. Rough set model yielded 100% classication accuracy on training set and 67% on validation set. The GP model obtained 82.6% accuracy on the training set and 80.3% on the validation set. This was signicantly higher than the accuracy achieved by the rough set model. The type I and type II errors were analyzed using second genetic model. New model was trained using the same GP algorithm, except that the validation sample of rst GP model was used as the training data for second GP model. These two models yielded 81% and 83% accuracies respectively over the entire sample. They concluded that the GP approach coupled with rough sets could be ecient approach for bankruptcy prediction problem. Bian et al. [13] proposed a new fuzzy-rough-nearest neighbour hybrid for bankruptcy prediction. They compared it with crisp K-NN and fuzzy K-NN. Fuzzy-rough K-NN provided better results in identifying the non-protable companies. When using decision tree feature selection method, fuzzyrough K-NN had the lower type I error of 25%. Overall, they concluded that fuzzy-rough K-NN performed better in minimizing type I error, while having satisfactory type II error. Pendharkar and Rodger [88] studied GA-based ANN on bankruptcy prediction problem. They chose arithmetic crossover operator for the GA-based ANN. They used real-valued GA to learn the connection weights in an ANN. They used two datasets of which the rst one is taken from [49] and second data set was a real-life data set. They showed that GA-based
ANN training showed resistance towards overtting by keeping the ANN architecture constant. Further, they concluded that GA-based ANN with 1-point crossover, arithmetic crossover and uniform crossover performed comparably with BPNN on holdout sample. Tung et al. [114] proposed a new neural fuzzy system, viz., the generic self-organizing fuzzy neural network based on the compositional rule of inference, GenSoFNN-CRI(S), to predict banking failure. The interaction between the features was captured in the form of IF_THEN fuzzy rules. The GenSoFNN-CRI(S) was compared with the Coxs proportional hazards model, BPNN and the modied cerebellar model articulation controller (MCMAC). They performed v-fold cross-validation. They concluded that the GenSoFNN-CRI(S) outperformed Coxs model in minimizing type I error. However, the GenSoFNN-CRI(S) yielded higher type II error rate. They observed that the MLP outperformed both the MCMAC and the GenSoFNN-CRI(S). Tseng and Lin [112] proposed a hybrid quadratic interval logistic regression analysis based on quadratic programming. Their model combined the advantages of logistic regression and Tanakas [109] quadratic interval regression model, a variant of fuzzy regression analysis. They obtained a classication rate of 78%. 12. Discussion The following observations can be made from the current review paper. Table 2, where the nancial ratios used in each paper were presented, indicates that a majority of papers considered many nancial ratios whereas a few of them considered the Altmans variables, which were published in 1968. This shows that from the domain point of view, the bankruptcy research has matured considerably as researchers started attaching more importance to other nancial ratios as well. Table 3 presents other dimensions of the review, wherever available. This table indicates that a vast majority of the studies reviewed here pertain to rms and not banks. Further, majority of the studies are conducted by taking the data sets relevant to the time period 19802003. Moreover, for a vast majority of the works, the country of origin of the data sets is USA followed by European countries. Further, it is observed that a variety of statistical and intelligent techniques have already been applied to the bankruptcy prediction problem.
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The general observation is that the statistical techniques such as logistic regression, LDA, QDA, FA were all outperformed by the most popular NN architecture viz., BPNN, wherever comparisons were made between these two families of techniques. This is not surprising because the BPNN with logistic activation function can be thought of as a conuence of several logistic regressions tted together in parallel. Thus, the non-linearity in the data can be modeled better by the BPNN. Comparing decision trees with NN architectures, even in cases where they yield identical performance, we recommend the use of decision trees as they produce an important by-product viz., ifthen rules. These rules can be used as an early warning expert system later on. Depending on the data set, both techniques are capable of outperforming each other in terms of accuracy. However, in the case of bankruptcy prediction problems, BPNN outperformed the decision trees such as C4.5 and ID3 in terms of accuracy. Further, BPNN, DA and logistic regression outperformed the CBR implemented without weights. Thus, CBR with the simple k-nearest neighbor method at its heart cannot solve classication problems with nonlinear boundaries. Also, CBR cannot generalize well. Then, rough set based approach outperformed DA, logistic regression and a decision tree. However, rough set based approaches can be, in general, inaccurate and sensitive to changes in data. As regards DEA, it yields us only the relative scores of the eciency levels of the banks. On the other hand, SVM can be very accurate and does not have local minima problems unlike BPNN and it can also be trained with a small training set. It is observed that SVM outperformed DA, logistic regression and BPNN. Fuzzy logic based techniques are least exploited in bankruptcy prediction research. In the few studies where they were applied, fuzzy rule based classier outperformed LDA and logistic regression, but BPNN outscored fuzzy rule based classier. More importantly, fuzzy ifthen rules can be used as early warning fuzzy expert systems. In general, in the soft computing architectures, ensemble classiers outperformed the individual models, which is on the expected lines. Further, it can be observed that the interest to design and employ a variety of soft computing architectures has increased signicantly over the past decade. In view of the foregoing and from Tables 2 and 3, the authors noticed a signicant trend in the
bankruptcy prediction research. The interest and condence in techniques such as fuzzy rule based classiers, SVM, rough sets, isotonic separation etc has grown enormously during the past 5 10 years. Statistical techniques are no longer preferred in view of their low accuracy. Further, the BPNN is also very much exploited. Other NN architectures deserve much wider application in this eld. However, decision trees such as CART are not employed as much as they deserve. 13. Conclusions and future directions A comprehensive review is conducted on the research work done during 19682005 in the application of statistical and intelligent techniques to solve the bankruptcy prediction problem in banks and rms. The review is organized by taking the type of technique as an important dimension besides others such as the source of data sets and variables used and the comparative performance of techniques in terms of prediction accuracy, wherever available. An important conclusion that can be drawn from the review is that researchers employed almost all intelligent techniques to solve this important problem. The review indicates that statistical techniques in stand-alone mode are no longer employed and among the stand-alone intelligent techniques, neural networks were the most often used family followed by rough sets, CBR, OR techniques, evolutionary approaches and other techniques subsuming fuzzy logic, SVM, etc. An important trend has been to build soft computing architectures (hybrid intelligent systems) for the problem. This review supports the popular opinion that ensemble classiers, by and large, outperform the individual techniques, that constitute the ensemble classiers. As regards future directions, a lot of scope still exists in developing new hybrid systems in various forms for the problem. The full potential of intelligent techniques such as SVM, fuzzy logic, collaborative ltering and hitherto unused neural network architectures such as radial basis function network, reduced coulomb energy network, generalized regression neural network, counter propagation neural network, adaptive resonance theory (ART) network and decision trees such as CART, TreeNet, random forests can be exploited. Given the limitations of all intelligent techniques in stand-alone mode, the authors feel that it is worthwhile to investigate newer soft computing architec-
25
tures (hybrid intelligent systems) in order to amplify the advantages of the individual models and minimize their limitations. One such hybrid system could focus on exploiting the enormous domain knowledge that is extant for this problem besides using data-driven modeling. The rst module of such a hybrid could use the nancial domain experts experiential knowledge to build a fuzzy inference system while the second module could be any of the intelligent techniques such as neural networks, decision trees, etc. References
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[2] [5] [6] [7] [8]

[19] [24] [26]

[29] [31] [36] [37]

6 Table 2 (continued) Ref # [45] [51] Variables

[73] [74] [75] [78]

8 Table 2 (continued) Ref # [101] [102] [104] [106] Variables

[121] [122] [124] [126] [128]

2067 37 39 2085 40 366 150 78 102 36 200 66 39 12

19851986 1988 19751994 19942001 19941996 19751976 19801990 19711981

1988 (continued on next page) 9

[46] [47] [48] [51]

Several Firms Firms Firms

[52] [53] [54] [55] [57] [62] [63] [64] [65]

Banks Firms Firms Firms Banks Firms Firms Firms Firms

542 544 8241

19911993 19911993 19962003

24 50 1500 1137 8977 282 34 364 166

[66] [67] [69] [70]

Firms Firms Firms Firms

168 88 1133 921

19951998 (2, 3) 1984 1988 (3) 19801999 (1)

[73] [74] [75] [78] [79] [80]

Firms Firms Firms Firms Firms Firms

200 291 291 110 1888 150

[85] [86] [88] [89]

66 2144 100 182 202 48

19971985 19951998 19891990 19871989 19851987 (1 and 2) 1980

#Samples Source of data/country of origin Table 3 (continued) Bank/rm Ref #

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