Ebook Comparing the performance of market-based and accounting- based bankruptcy prediction models
There is renewed interest in credit risk assessment, inter alia, driven by the requirements of Basle II and explosive growth in the credit derivatives market. This, and the concern about the lack of theoretical underpinning of traditional accounting-ratio-based models such as the Altman (1968) z-score, has led to the application of the contingent claims valuation methodology for predicting corporate failure with the KMV model now extensively employed by banks and financial institutions. However, empirical tests of the relative power of the two approaches are lacking in the literature. The only published study, that of Hillegeist et al. (2004), is deficient in comparing the market-based approach with the Altman (1968) and Ohlson (1980) accounting-ratio-based models which are known to suffer from high misclassification rates (e.g. Begley et al., 1996). It also does not take into account differential error misclassification costs and the economic benefits of using different credit risk assessment approaches. In any case, a more valid comparison would be with the commercially available Zeta (Altman et al., 1977) model which has far superior performance (e.g. Altman, 1993:219-220).
Under Basel II, banks are allowed to use internal ratings-based approaches to set capital charges with respect to the credit risks of their portfolios. Hence, research in thisarea assumes greater significance because a poor credit risk model could lead to sub-optimal capital allocation.
Accounting-ratio based models are typically built by searching through a large number of accounting ratios with the ratio weightings estimated on a sample of failed and non-failed firms. Since the ratios and their weightings are derived from sample analysis, such models are likely to be sample specific. Mensah (1984) finds that the distribution of accounting ratios changes over time, and hence recommends that such models be redeveloped periodically. In addition, the very nature of the accounting statements on which these models are based casts doubt on their validity: (i) accounting statements present past performance of a firm and may or may not be informative in predicting the future, (ii) conservatism and historical cost accounting mean that the true asset values may be very different from the recorded book values, (iii) accounting numbers are subject to manipulation by management, and in addition, (iv) Hillegeist et al. (2004) argue that since the accounting statements are prepared on a going-concern basis, they are, by design, of limited utility in predicting bankruptcy.
Market-based models using the Black and Scholes (1973) and Merton (1974) contingent claims approach provide a more appealing alternative and there have been several recent papers using this approach for assessing the likelihood of corporate failure (e.g., Bharath and Shumway, 2004; Hillegeist et al., 2004; Reisz and Perlich, 2004; Vassalou and Xing, 2004; Campbell et al., 2006). Such a methodological approach counters most of the above criticisms of accounting ratio-based models: (i) it provides a sound theoretical model for firm bankruptcy, (ii) in efficient markets, stock prices will reflect all the information contained in accounting statements and will also contain information not in the accounting statements, (iii) market variables are unlikely to be influenced by firm accounting policies, (iv) market prices reflect future expected cashflows, and hence should be more appropriate for prediction purposes, and (v) the output of such models is not time or sample dependent.
However, the Merton model is a structural model and operationalizing it requires a number of assumptions. For instance, as Saunders and Allen (2002: 58-61) point out, the underlying theoretical model requires the assumption of normality of stock returns. It also does not distinguish between different types of debt and assumes that the firm only has a single zero coupon loan. In addition, it requires measures of asset value and volatility which are unobservable. It is therefore not surprising that the empirical evidence on the performance of market-based models is mixed. Kealhofer (2003) and Oderda et al. (2003) find that such models outperform credit ratings, and in their empirical comparisons Hillegeist et al. (2004) suggest their derived model carries more information about the probability of bankruptcy than poorly performing accounting-ratio based models. On the other hand, Campbell et al. (2006) find such market-based models have little forecasting power after controlling for other variables. Similarly, Reisz and Perlich (2004) find that Altman’s (1968) z-score does a slightly better job at failure prediction over a 1-year period than both their KMV-type and computationally much more intensive down-and-out barrier option models, though their market-based models are better over longer horizons (3 to 10 years).
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