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.