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Logistics and
Predicting probability of default Z-score model
of Indian corporate bonds: logistic approaches
and Z-score model approaches
255
Arindam Bandyopadhyay
National Institute of Bank Management (NIBM), Kondhwe Khurd, Pune, India
Abstract
Purpose – This paper aims at developing an early warning signal model for predicting corporate
default in emerging market economy like India. At the same time, it also aims to present methods for
directly estimating corporate probability of default (PD) using financial as well as non-financial
variables.
Design/methodology/approach – Multiple Discriminate Analysis (MAD) is used for developing
Z-score models for predicting corporate bond default in India. Logistic regression model is employed to
directly estimate the probability of default.
Findings – The new Z-score model developed in this paper depicted not only a high classification
power on the estimated sample, but also exhibited a high predictive power in terms of its ability to
detect bad firms in the holdout sample. The model clearly outperforms the other two contesting models
comprising of Altman’s original and emerging market set of ratios respectively in the Indian context.
In the logit analysis, the empirical results reveal that inclusion of financial and non-financial
parameters would be useful in more accurately describing default risk.
Originality/value – Using the new Z-score model of this paper, banks, as well as investors in
emerging market like India can get early warning signals about the firm’s solvency status and might
reassess the magnitude of the default premium they require on low-grade securities. The default
probability estimate (PD) from the logistic analysis would help banks for estimation of credit risk
capital (CRC) and setting corporate pricing on a risk adjusted return basis.
Keywords India, Bonds, Modelling, Emerging markets
Paper type Research paper
Introduction
Corporate liabilities have default risk. There is always a chance that a corporate
borrower will not meet its contractual obligations and may renege from paying the
principal and the interest due. Even for the typical high-grade borrower, this risk is
there even though it may be small, perhaps 1/10 of 1 percent per year. Although these
risks do not seem large, they are in fact highly significant. They can even increase
quickly and with little warning. Further, the margins in corporate lending are very
tight, and even small miscalculations of default risks can undermine the profitability of
lending. But most importantly, many lenders are themselves borrowers, with high
levels of leverage. Unexpected realizations of default risk have destabilized,
decapitalized, and destroyed many internationally active lending institutions.
Following the release of the recent Reserve Bank of India (RBI) draft guidelines
(February 15, 2005) for the implementation of Basel II norms, the leading Indian banks The Journal of Risk Finance
Vol. 7 No. 3, 2006
are preparing to design appropriate internal credit risk models. The major motive is the pp. 255-272
incentive based approach for capital estimation for credit risk. In order to fetch the q Emerald Group Publishing Limited
1526-5943
early rewards of Basel II implementation, banks have to develop their own internal DOI 10.1108/15265940610664942
JRF models for credit risk. Internal models offer an opportunity for a bank to measure and
7,3 price counter-party risk and systemize risks inherent in lending. Prediction of default
probability (PD) for each borrower or group of borrowers is the key input for the
estimation of regulatory capital as well as economic capital for banks. It is also equally
important for the banking industry and financial institutions to discriminate the good
borrowers (non-defaulting) from the bad borrowers (defaulting). This will not only help
256 them in taking lending decisions but also practicing better pricing strategies to cover
against the counter party risk. While, internationally, considerable research has been
made to predict corporate default, very few attempts have been done for Emerging
Market like India.
The purpose of this paper is to build a robust framework that enables banks and
financial institutions in emerging market economy like India to classify a firm in the
default or non-default category based on the information of its financial variables. This
kind of model can serve as a useful tool for quick evaluation of the corporate risk
profile. Second, it can also be used to track the firms to check for their default status
over time. As a result such model can help banks to get an early warning signal about
the default status of its corporate clients. In this paper, we estimate an MDA model to
predict corporate default using a balanced panel data of 104 Indian corporations for the
period of 1998 to 2003. The financial ratios and other basic information are collected
from the Centre for Monitoring Indian Economy (CMIE) Prowess database. This
database is similar to the Compustat database in the USA. However, as we have
mentioned earlier, it is not enough to know a qualitative differentiation of
counter-parties for properly evaluating credit risk. One has to go one step further
and differentiate quantitatively between different counter-parties. Accordingly, we
also estimate probability of default (PD) of each firm for the same corporate portfolio
through logistic regression. Here we also explore the role of non-financial factors in
predicting default. For this purpose, we empirically examine whether the combined use
of financial and non-financial factors lead to more accurate PD estimates.
The rest of the paper is structured as follows. In the next section we discuss about
the data, definitions and construction of variables and hypotheses. The third section
portrays the corporate bond default rates across different rating grades in India as well
as industry wise default rates. In the fourth section, we demonstrate the development
of the Z-score model for Indian corporations, main results, and the model validation.
The fifth section presents the results and methodology of logistic analysis to predict
corporate bond defaults. Here we also compare the significance of financial and
non-financial parameters in describing default risk. We have also tested the predictive
power of logistic model. The sixth section discusses the main conclusions.
Literature survey
In theory, corporate insolvency is indicated either by fall in the asset value or due to
liquidity shortage (i.e. falls in the ability to raise capital to finance project). Therefore,
we should expect that the ratios that reflect the cash flow structure and movement of
market value of firm’s asset to be different among defaulted and solvent firms (Wilcox,
1971; Scott, 1981). Several later studies incorporated these theoretically determined
financial characteristics in the explanation of corporate default. For example, Casey
and Bartczak (1985), Gentry et al. (1985) and Aziz et al. (1988) used cash flow variables
in their model in predicting corporate failure. Opler and Titman (1994) and Asquith
et al. (1994) report that default is primarily caused by firm-specific idiosyncratic Logistics and
factors. On the other hand, researchers like Lang and Stulz (1992) and Denis and Denis Z-score model
(1994) argue for a systematic nature of bankruptcy risk. Kranhnen and Weber (2001)
presented a normative set of generally accepted rating principles that point out the approaches
necessity of links among industry risk, business risk, financial risk, management risk,
facility risk, and probability of default. Grunert et al. (2005) analyzed credit file data
from four major German banks and found empirical evidence that the combined use of 257
financial and non-financial factors leads to a more accurate prediction of future default
events than the single use of each of these factors. Other studies look at the relation
between default and the stock market. KMV Corporation of Moody (1993) using Black
and Scholes (1973) approach made an attempt to predict default in an option pricing
context; i.e. to model when the option to default has more value than the option to
continue.
Because of the lack of a unifying theory, there has been an explosion of different
empirical methods used to predict business failure in different markets. Statistical
models can help banks to predict default probability to get an early warning signal
about the default status of the corporate clients. Excellent reviews of the plethora of
studies can be found in Dimitras et al. (1996) and Mossman et al. (1998). The first
approach to predicting corporate failure has been to apply a statistical classification
technique called MDA to a sample containing both failed and non-failed firms. Studies
like Beaver (1966) and Altman (1968) pioneered this approach. Beaver (1966, 1968) did
univariate analysis of a number of bankruptcy predictors and set the stage for
multivariate attempts by him and others. He found that a number of indicators could
discriminate between matched samples of failed and non-failed firms for as long as five
years prior to failure. He also developed a Z-score model by using multivariate analysis
in 1968. In the same year, Altman developed his classic multivariate insolvency
prediction model (MDA) for publicly traded manufacturing firms in the USA. The
initial sample in his study is composed of 66 corporations with 33 firms in each of the
two groups distressed and solvent. The indicator variable Z-score forecasts the
probability of a firm entering bankruptcy within a two-year period (the cut-off score is
below 1.81). In the original Z-score formula for predicting bankruptcy Altman (1968)
employed working capital/total assets ratio, retained earnings/total assets ratio,
earning before interest and taxes/total assets ratio, market value of equity/book value
of total debt ratio, and sales/total assets ratio as predictor of financial health of a
company.
In Altman et al. (1977) constructed a second-generation model with several
enhancements to the original Z-score approach. The new model, which was called
ZETA, was effective in classifying bankrupt companies up to five years prior to failure
on a sample of corporations consisting of manufacturers and retailers. The ZETA
model tests included non-linear (e.g., quadratic) as well as linear discriminate models.
The non-linear model was more accurate in the original test sample results but less
accurate and reliable in holdout or out-of-sample forecasting. Subsequently, in Altman
et al. (1995) modified his Z-score model to emerging market corporations, especially
Mexican firms that had issued Eurobonds denominated in US dollars. In this enhanced
Z-score model, he dropped sales/total assets and used book value of equity for the
fourth and final variable to make it more suitable for the private firms.
JRF Several researchers influenced by the work of Altman (1968) on the application of
7,3 discriminant analysis, explored ways to develop more reliable financial distress
prediction models. Subsequently, new analytical techniques like logit or probit models
(Martin, 1977; Ohlson, 1980; Zavgren, 1985; Lennox, 1999; Westgaard and Wijst, 2001;
Grunert et al., 2005), multidimensional scaling (Mar Molinero and Ezzamel, 1991),
artificial neural networks (Tam, 1991; Wilson and Sharda, 1994/1995), multinomial
258 logit (Johnsen and Melicher, 1994), multicriteria decision aid methodology (Zopounidis
and Dimitras, 1998), etc. have been introduced to predict corporate failure in different
markets.
As one can see from the collective literature discussed above, a very large number of
empirical bankruptcy prediction models do multiple discriminant analysis (MDA)
pioneered by the seminal works of Altman (1968, 1995) based on the accounting data.
However, these models, though worked successfully, are very much country specific
and may not fit well with the Indian condition. The ratios as well as the weights of
MDA would differ across countries and regions (as one can see the Altman’s original
1968 model for US manufacturing firms is different from that of Emerging Market
model of 1995 based on Mexican data). Further, Z-score model only gives prediction
about the qualitative differentiation of counterparties. If banks are interested to
directly estimate the probability of default (PD), MDA analysis is not applicable since it
does not produce such probabilities.
One possible solution for banks, which intends to estimate PD directly, is the use of
limited dependent logit model (similar to Amemiya, 1981; Maddala, 1983). Unlike the
discriminant model, the logistic model has the flexibility to incorporate both the
financial as well as non-financial factors in predicting default. While the financial
ratios capture the firm specific information, the non-financial factors help to evaluate
the link of the firm with macroeconomic factors and the capability of the firm to churn
out cash flow in the required numbers.
In the logit analysis, we have included another financial variable: MVE_BVL – the
equity market value over the book value of the liabilities proxy for the firm’s asset
values. It also measures the solidity of the firm. In calculating book value of total
liabilities, total net worth of the firm is subtracted from the total liability of the firm.
Hence, the BVL gives the book value of total outside liabilities of the firm.
All the six ratios represent either value or income of the firms with respect to total
assets. They are all hypothesized to be either positively related to solvency or
negatively related to the firm’s default probabilities.
Following non-financial variables are taken from the existing literature about
corporate solvency:
.
Age of the firm. Age of the company since incorporation. A relatively young firm
will probably show a low retained earnings/total assets (RE/TA) ratio because it
has not had time to build up its cumulative profits (Altman, 2000). Therefore, it
may be argued that the young firm is somewhat discriminated against in this
analysis, and its chance of being classified as bankrupt is relatively higher than
that of another older firm, ceteris paribus. But, this is precisely the situation in
the real world. The incidence of failure is much higher in a firm’s earlier years
[40-50 percent of all firms that fail do so in the first five years of their existence
(Dun and Bradstreet, annual statistics)]. The age effect is thus clear: young firms
are more likely to default. We take natural log of the number of years of the firm
since incorporation as measure of firm age.
.
Group ownership. Studies covering various countries have found that firms
associated with top business groups have greater stability in the cash flows and
show better productivity as well as risk sharing than unaffiliated firms
(Gangopadhyay et al., 2001). Together with the existence of mutual debt
guarantees through group affiliation, firms may reduce the possibility of
financial distress. Some studies delineating the effect of Indian business group
affiliation on firm sales have observed that top 50 business group firms have a
better reputation advantage in the product market and are likely to export more.
They are also on average spend more advertising, marketing, distribution and
research and development (R&D), and thus have larger amount of intangible
assets (Bandyopadhyay and Das, 2005). Accordingly, we can hypothesize that
top 50 business group firms are safer firms than their non-top 50 group
counterparts.
.
ISO Quality Certification (ISOD). This dummy is taken as a product market
signal about the firm that it maintains a quality management system and is
concerned with customer expectations and satisfactions. It has been empirically
observed that ISO certified firms are successful in the product market Logistics and
(Bandyopadhyay and Das, 2005). Therefore we assume that possessing an ISO Z-score model
certificate by a firm would reduce its chance of default.
.
Control variables-industry characteristics. The industry factors affect the firms’
approaches
performance and therefore affect default as well. There are incidents of clustered
incidents of default. In order to capture the industry specific effects, our sample
firms have been classified into 11 industry dummies depending on its major 261
economic activity.
Year 2
Year 1 AAA (%) AA (%) A (%) BBB (%) BB (%) B (%) C (%) D (%)
Z ¼ b0 þ b1 X 1 þ b2 X 2 þ b3 X 3 þ . . . þ bk X k
where D ¼ discriminant score, bs ¼ discriminant coefficients or weights, and X s ¼
predictors or independent variables. The coefficients, or weights (b), are estimated so
that groups differ as much as possible on the values of the discriminant function. This
occurs when the ratio of between-group sum of squares to within-group of sum of
squares for the discriminant scores is at a maximum. Any other linear combination of
the predictors will result in a smaller ratio. The test statistics used for carrying out this
analysis is F and Wilk’s Lambda. Intuitively, a small Lambda signifies that a small
proportion of the total variance of the constituent variables is being accounted for by
within groups’ dispersions while a larger proportion of the total variance is explained
by the squared deviation of the between group means from their pooled mean. This
would be translating to a high value of the F-statistic, which means a greater chance
for the null of equal means to be rejected.
Market Score Model (1995). Model 3 of Table V is ours. This new Z-score model
comprises of five ratios. Two of these ratios are same to those in Model 1 namely
working capital to total assets (WK_TA) and sales over total assets (SALES_TA).
Three new variables are cash profits to total assets (CASHPROF_TA), solvency ratio
(SOLVR), and operating profit over total assets (OPPROF_TA). The discussion on the
expected signs of these ratios has already been done in variable definitions section.
Although Model 1 and Model 2 exhibit a reasonable high degree of classification
power, Model 3 (which is ours) has the best ability to classify the current sample of
good and bad firms. However, the robustness of Model 3 needs to be established by a
set of diagnostic tests.
The first set of tests pertains to checking the difference of the means of the two
groups, both individually and also as a whole for the entire function. From Table VI,
the magnitude of the Wilk’s Lamda and F-statistic of the individual variables (used in
Model 3) suggests that given the data, the likelihood of the means of the solvent and
defaulted groups to be equal is highly unlikely. Hence, the null hypothesis of the
equality of means with respect the same variance co-variance matrix for both the
Solvent Defaulted
(DEF ¼ 0) (DEF ¼ 1) Wilk’s Lambda for F-stat. for difference
Mean Std dev. Mean Std dev. difference in mean in mean
Using the above two equations, we obtain two scores for the same firm. In the next
step, the final Z-score obtained in Model 3 denotes a reduced form representation of the
above two discriminant equations (i.e. the difference between solvent and defaulted
score):
Z ¼ Zsolvent 2 Zdefault
or:
0 79 79 88
1 59 73 88
2 55 50 68
3 – – 57 Table VII.
4 – – 56 Relative comparison of
5 – – 45 classification and
6 – – 45 predictive accuracy of
three discriminant
Notes: Using a holdout sample of 37 Indian corporate bonds defaulted between the year 1996-2005. models: early warning
Also using 0 as the cutoff score signal (time dimension)
JRF the long run predictive power of our model with Model 1 and Model 2. Our model (i.e.
7,3 Model 3) clearly out performs the other two models even if one goes back two years
prior to default (with 68 percent accuracy). Moreover, the type I accuracy rate of Model
3 is pretty high (88 percent) on data from one financial statement prior to default on
outstanding bonds.
PD ¼ FðZ Þ
¼ 1
1þe 2Z
¼ 1=1 þ e 2ðb0 þb1 X 1 þb2 X 2 þb3 X 3 þ...þbk XÞ
0 94 95 97
1 95.3 95.3 96.3
Table VIII. 2 82.5 85 87
Relative comparison of 3 73 73 78
bankruptcy prediction 4 62 68 73.3
power of three 5 55 56 68.1
discriminant models: Notes: Using a holdout sample of 148 Indian Manufacturing Firms reported bankrupted by Board for
early warning signal Industrial and Financial Reconstruction (BIFR) of India in the year 2004. Also using 0 as the cut-off
(time dimension) score
We have applied Maximum Likelihood Estimation (MLE) procedure for estimation of Logistics and
the parameters. Z-score model
In the logit regression, our purpose is to evaluate the role of balance sheet variables
as well as the non-financial variables in predicting corporate bond default and to arrive approaches
at an estimate of probability of default for a firm using them.
Before we discuss our results, let us first look at the descriptive statistics of the
variables used in the logistic regressions. Table IX, gives us some descriptive statistics 267
about the sample of firms used in the logistic analysis. It is evident from the descriptive
statistics table that all the financial ratios for solvent group of firms on average look
relatively better than their defaulted counterparts. As far as the non-financial parameters
are concerned, the greater percentage of solvent firms possess ISO certificate than the
defaulted firm. Similarly, defaulted firms are on average younger than the defaulted
firms. The solvent firms also mostly belong to the top 50 business groups than the
defaulted ones. The difference is also statistically significant as evident from the
t-statistics reported in column 8[5]. Furthermore, standard deviations of financial ratios
are very high for defaulted companies in comparison to the solvent firms.
younger firms are more risky than the older firms. It is more likely that matured
firms have established a reputation with credit institutes and private investors that
alleviates the asymmetric information problems because an extended period of
scrutiny would permit a better understanding of the economic viability of the firm.
In the case of a liquidity crunch, an older firm could rely on such a relationship to
obtain additional lines of credit or favorable grace periods and can avoid a
corporate default event. On the other hand, young firms have less time to solidify
a relationship with its creditors and private investors hence increasing the chance
of financial distress during a credit crunch.
Similarly, the likelihood of default is less if the firm belongs to the top 50 business
group. Likewise, the ISO dummy (ISOD) has negative influence on the probability of
default (DEF), indicating that the firms that maintain a quality management system have
less chance of default. The industry dummies are significantly different from zero
suggesting that we cannot reject the presence of industry effects on firm’s default status.
Now, let’s compare the diagnostic tests of these models. As reported in the lower panel
of Table X, Pseudo R 2 is highest (0.70) in Model 1 in comparison to Model 2 (0.66) and
Model 3 (0.57)[6]. The chi-square statistics is also highest in case of Model 1. We also
checked the predictive power of the logistic models by using ROC graphs in Figure 1 and
calculate the area under the ROC curve based on the model estimates by logit[7]. One can Logistics and
clearly see from Figure 1 that Model 1 has the highest within sample prediction power of Z-score model
97.2 percent in comparison to Model 2 and Model 3. Further, we have performed a
chi-squared test to summarize the predictive accuracy of these three models into a approaches
summary statistic. The chi-squared test yielded a significance probability of 0.001
suggesting that there is a significant difference in the areas under the three ROC curves.
Hence, it is evident from our results that inclusion of non-financial factors along with the 269
financial factors improves the default-forecasting ability of the model. The results of
Model 1 indicate a strong relationship between default and the financial and non-financial
variables. The Model 1 can be directly used for finding PDs in credit-risk models[8].
Figure 1.
Comparison of ROC
curves for three models
Predicted group
Notes
1. CRISIL defines default as a credit event where the underlying corporate has missed
payments (a single day’s delay or a shortfall of even a single rupee) on a rated instrument in
terms of the promised repayment schedule. CRISIL’s rating does not factor in any post
default recovery.
2. A paired t-test on the mean asset difference between the two groups had shown statistically
insignificant results.
3. The probability of default (PD) per rating grade counts the average percentage of bond in
this rating grade in the course of one year.
4. It is empirically observed fact that the linear discriminant model has a higher holdout
sample predictive power compared to the quadratic discriminant model (Altman, 1993).
Moreover, the former is more amenable for interpretation compared to the latter.
5. A Wilcoxon rank-sum test showed that all the financial and non-financial parameters are
significantly better for solvent group (at 1 percent or better level) than the defaulted group.
6. Pseudo R 2 is a likelihood ratio index, which is analogous to the R 2 in a conventional
regression model. Here Pseudo R 2 ¼ 1 2 Lmax =L0 , where L0 is the initial value of likelihood
function and Lmax is the highest value.
7. Receiver Operating Characteristic Curve (ROC) quantifies the accuracy of diagnostic tests to
discriminate between defaulted firms and solvent firms using each value of the logit score as
a possible cutoff point. The analysis uses the ROC curves of the sensitivity (percentage of
true defaulted outcomes correctly specified) vs. 1-specificity (percentage of false defaulted
outcomes correctly specified) of the diagnostic test. This calculates the area under the ROC
curve based on the model estimated by logistic regression predictions. The greater the area
under the ROC curve, the better the predictive power of the model. Therefore, a steeper curve
from the diagonal line indicates a more powerful model.
8. From Table results of Model 1, one can estimate the probability of default (PD) by using the
1
Logistics and
following equation: PDi ¼ 1þexpð2z , zi ¼ a þ bX i , where a is the intercept and b represents
iÞ
the parameters that may explain default incidents. Z-score model
approaches
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Further reading
Eisenbeis, R.A. (1977), “Pitfalls in the application of discriminant analysis in business, finance
and economics”, Journal of Finance, Vol. 42, pp. 875-900.
Corresponding author
Arindam Bandyopadhyay can be contacted at: arindam@nibmindia.org