The study of credit risk evaluation based on DEA method

Huaipeng Li
Department of Mathematics & Institute of Finance
Engineering, Jinan University
Guangzhou, China
lihp2006@163.com
Sulin Pang

Department of Public Administration & Institute of Finance
Engineering, School of Management, Jinan University
Guangzhou, China
pangsulin@163.com

AbstractBased on studying the KMV default distance model,
the work of this paper is to calculate the default distance using
BCC model in DEA methodology to quantify the credit risk.
The principle idea is to use DEA value of the company to
replace the market value of the company in KMV model, and
use average DEA points of ST companies within the industry
instead of default point, then get the Default Distance. The
third part is an empirical analysis which using 17 Chinese
textile companies in 2007 and 2008, the result shows that
default distance calculated with the DEA method does not
completely reflect the company's credit risk, but as a
discussion of method, the default distance with the DEA
method still have research value.
Keywords-credit risk; default distance; DEA;
BCC model
I. INTRODUCTION
Credit risk is that one party in a deal is in the risk of loss
while the other party is unable to keep the promise, but also
that the default bring the creditor risk of loss caused by
debtor who is unable to repay its debt. It can be translated
into the measurement of the financial situation of enterprises
that banks measure its customers credit risk, because the
formation of credit risk - whether the enterprise can be
scheduled debt service depends on the financial situation of
enterprises. There are many factors affecting the financial
situation, so, to assess the financial situation, we should use
multi-dimensional indicators affecting the financial situation,
but not a particular indicator [1].
So far, scholars analysis enterprises credit risk by using
various methods which generally can be attributed to the
following two ways[2]: one is a comprehensive analysis
based on financial ratios, of which the typical
representations are linear probability model, Logistic model,
Probit model, and discriminate analysis model, etc. The
other is a analysis phase based on modern financial theory
and information science theory including the KMV model,
Credit risk + model, Credit metrics models.
In recent years, a classification method called non-
parameter data envelopment analysis (DEA) is paid attention
widespread and studied deeply. It integrates multi-input
indicators to a composite input index, and multi-output
indicators to a composite output index, then determines the
two composite indexes rationality and effectiveness and
divides the evaluated subjects into two major categories of
relatively effective and ineffective, representing counter-
performance and default, respectively.
Yeh was one of the first scholars using financial ratios to
analysis DEA [3]; she combined DEA method with the
analysis of financial ratio to study bank performance. By
empirical analysis ,she found that DEA method can be used
to analysis bank's financial operating strategy through
dividing financial ratios into different dimensions according
to different meanings effectively . Emel and others used
DEA method to evaluate the company's credit risk according
to financial indicators [4]. Troutt and others, in 1996,
proposed a decision-making system based on an credit
accepted cases set given by experts, which formed piece
wise linear separating hyper plane as the credit boundary of
accepted set and refused set, talked about how to determine
the credit status of new units only knowing the credit stand
of good credit flats [5]. In 1998, Teiford, who improved the
system, proposed a DEA-type linear programming model, so
that we can judge new cases credit easier, and can easily
determine the location of new case relative to the boundary
[6]. Zhaohan Sheng, Guangmou Wu and others have studied
that in the DEA model, with the number of evaluation
indicators increasing, the effectiveness factor of each
decision making unit will increase. Most or all of DMU
efficiency would reach 1, if the number of indictors is up to
a certain extent [7]. In order to get a reasonable degree of
differentiation evaluation result we usually take that the
number of objects DMU is not less than two times of the
total number of input and output indicators [8], there are still
researchers thinking that the number of DMU should be at
least three times of the total number of input and output
indicators [9]. When the number of DMU changes largely,
we must re-select the evaluation index, which is obviously
undesirable.

II. THE KMV / DEA MODEL OF CREDIT RISK
A Introduction of KMV model
KMV model is developed as a credit risk measurement
tool by risk management firm called KMV. In the KMV
model, default risk is defined as probability that enterprises
asset value is less than default point. Default distance is a
ratio index measuring the size of default risk, it can embody
the degree that how company's assets is close to default
point before the financial crisis. Default distance is
calculated in KMV model as follows:
2010 International Conference on Computational Intelligence and Security
978-0-7695-4297-3/10 $26.00 2010 IEEE
DOI 10.1109/CIS.2010.25
82
2010 International Conference on Computational Intelligence and Security
978-0-7695-4297-3/10 $26.00 2010 IEEE
DOI 10.1109/CIS.2010.25
81
2010 International Conference on Computational Intelligence and Security
978-0-7695-4297-3/10 $26.00 2010 IEEE
DOI 10.1109/CIS.2010.25
81



'
( )
( ')*
E V DP
DD
E V

. (1)

In formula (1), represents expected asset value,
( ') E V

represents the companys assets volatility (it can be

substituted by standard deviation of capital gains in a certain
period). and
( ') E V
are calculated in the classic model
called Black-Scholes-Merton option pricing model.
DP represents the default point namely the debt that the
company must repay after a certain period, In KMV model,
default occurs when the company's asset value below a
certain level. At this level, the value of the assets is defined
as the default point (DP). KMV Company found that the
most frequent critical default point is equal to half of current
liabilities plus long-term liabilities according to a lot of
empirical analysis. That is DP = SD +0.5 * LD [10], SD is
the company's short-term liabilities, LD is the company's
long-term liabilities.
Although default distance can quantify credit risk, and
warn the companys financial crisis effectively, but there are
still shortcomings in KMV model: (1) The model assumes
that assets value satisfy the normal distribution, but in reality
not all of the borrowers assets value meet normal
distribution; (2)For non-listed companies, we must use the
historical financial data, whose timeliness greatly reduce; (3)
Default point is set too hastily, which are not able to
distinguish between different types of long-term debt, nor
take industry and macroeconomic conditions into
consideration, although the set of default points is supported
by the United States empirical data, but Chinese economic
and capital market is still in the high-speed development,
and differ from the U.S. economic situation.
B Introduction of DEA method
DEA (Data Envelopment Analysis, DEA) is a new
interdisciplinary research field among operation research,
management science and mathematical economics [11]. It is
made by Charnels and Cooper in 1978 [12]. DEA method is
based on concept of relative efficiency, take mathematical
programming as the main tool and optimization as the main
method, then according to many indicators of input and
output data of multiple indicators the same type of units
(departments or enterprises) to evaluate the relative
effectiveness or efficiency of multi-comprehensive
evaluation of indicators.
Specifically, the first step is finding out indicators
affecting decision making unit(DMU)efficiency level, then
analysis how they affect the efficiency level: the greater
indicator value is, the higher DMU efficiency levels is, or
inverse [13]. Take the latter indicators as input variables,
and the former indicators as output variables. We can
measure the relative position of the effectiveness of decision
making units by using DEA model that is the relative level
of efficiency ranking. According to input-oriented DEA
formula, the performance indicators of output is denoted as
E, and E ranges from 0 to 1 [14].
CCR model is the first model of DEA method which is
used to evaluate the relative efficiency of decision making
units. CCR model has four basic assumptions, namely
convexity, invalidity, minimum and constant returns to scale.
It is obviously not appropriate to assume constant returns to
scale when evaluating company efficiency, therefore, we
should abandon CCR model, and take the BCC model with
variable returns to scale.
C KMV/DEA model
In this paper, we take 3 steps when taking KMV / DEA
model: First, calculate efficiency value (DEA value) of each
decision making unit (that is company in this paper) through
the BCC model. Second, compute the value of each
company. Finally, calculate default distance for each
company. Model used as follows:
Assume there are n decision making units (1in), Each
unit has m inputs and s outputs. Denote the input and output
indictors of DMU as vector form as follows:
1 2
( )
T
i i i mi
x x x x

1 2
( )
T
i i i si
y y y y

For each decision making unit (1 i n), solute the
following maximization problem:

*
0 0
1 1 1
min
. . , , 1, 0,1,2
, 0,
n n n
j j j j j j
j j j
st X S X Y S Y j n
S S

(2)

The model (2) is input-oriented BCC model.
Banker(1984) pointed out that there can exists negative
output factors in input-oriented BCC model and negative
input factors an in output-oriented BCC model according to
the theorem of invariance under the transformation. The
optimal value

*

is the efficiency value of DMU (DEA

value), then put it in the default distance in KMV model:


'
( )
( ')*
E V DP
DD
E V

. (3)

The optimal value
*

also represents companys credit

level, so it can substitute the objective assets value .
Then, taking ST companies average DEA value as default
point and the standard deviation of quarterly Rate of Return
on Common Stockholders Equity as the company's capital
volatility
( ') EV

, we can get relative default distance.

III. EMPIRICAL ANALYSES
A. Index for selection
Combining research purposes, data sciences and the
characteristics of credit risk evaluation, we select short-term
debt / current liabilities, asset-liability ratio, current
liabilities / Prime operating revenue as input indicators,

83 82 82

receivable turnover ratio, profit rate of asset, and current
ratio as the output indicators.
Input factors: the short-term debt / current liabilities can
reflect the short-term debt accounted for the proportion of
current liabilities. This indicator can fully reflect bank loans
in the proportion of the corporate loans , indicating that the
smaller the value is, the weaker dependence of the
company's debt on banks, the more easily enterprise repay
the loans and the smaller possibility of default. Current
liabilities / Prime operating revenue can reflect the solvency
of an enterprise, the smaller the indicator is, the stronger the
companys solvency is, the smaller corporate default risk is;
asset-liability ratio can explain the situation of capital
structure, the smaller the value is, the stronger corporate
liquidity is, the smaller corporate default risk is.
Output factors: the greater current ratio is, the better
capital liquidity is, the more easily repay the debt; profit rate
of asset is a measure of the profitability of enterprises, and
the larger it is, the stronger company's profitability is. That
means enterprises have more funds to repay bank loans, so it
can be said that the larger the index is, the better the credit
status of enterprises is. Receivable turnover ratio measures
the enterprise's management ability, the larger it is, the better
business conditions is [15].
In summary, 3 input indicators and 3 output indicators
are used in this empirical analysis as table shows as
follows:
TABLEI. INDICTORS USED IN THIS PAPER.

Item Input
indicators
Output
indicators
Ind-
ex
X1 X2 X3 Y1 Y2 Y3
Me-
anin
g
short-
term
debt
/current
liability-
es
Current
liability-
es /Prime
operati-
ng reve-
nue
asset-
liabilit
y ratio
current
ratio
Profit
rate
of
asset
Rece-
ivable
turno-
ver
ratio

B. Samples for selection
There are industry differences between listed
companies and seasonal differences between selling
products, in order to avoid error caused by the above
differences ,we select 17 textile companies in 2007 (of
which 3 ST companies )and 16 textile companies in 2008(of
which 6 ST companies) as samples, which are listed
companies in China Stock Exchange A. All the data come
from financial statements, such as quarterly reports,
semiannual reports and annual reports in Resset database
(www.resset.cn) and Genius of financial database.
C. Results
Using input-oriented BCC model, we can get the
companies operating efficiency (DEA value) through
MyDEA software. Then, taking ST companies average
DEA value as default point and the standard deviation of
quarterly Rate of Return on Common Stockholders Equity
as the company's capital volatility, applying the definition
principle of default distance in KMV model, we can get the
default distance of each company as table ] and table ]
show as follows:
TABLEII. l Dll^|T DTST^\Cl Ol ! Tl\TTl COMl^\TlS T\ ?00. T|
Stock
TABLEIII. T|l Dll^|T DTST^\Cl Ol !b Tl\TTl COMl^\TlS T\ ?008.
Stock
Code
Stock
Name
DEA
value
Standard
Deviation
Default
Distance
000712
GOLDEN
DRAGON 1 1.36 18.312
000803 JYAC 1 3.263 7.632
000301 CESM 0.907 2.32 7.414
000045 STHC 1 4.172 5.969
000779
SANMAO
PAISHEN (2009ST) 1 4.731 5.263
000726 LTTC 1 5.994 4.154
000018
VICTOR
ONWARD (2009ST) 1 7.415 3.358
000681
FAREASTSTOCK
CO.LTD(2009ST) 1 10.174 2.448
000976 CHGF 1 14.933 1.667
000955 XLKG (2009ST) 0.539 21.342 -1.843
000036 UDC (2009ST) 0.577 12.786 -2.358
000158 CSTEX 0.707 2.528 -2.462
Code
Stock
Name
DEA
value
Standard
Deviation
Default
Distanc
e
000018 VICTOR
ONWARD(2008ST)
1 18.87 0
000301 CESM 1 2.111 0
000681 FAR EAST
STOCK CO.LTD
1 25.681 0
000712 GOLDEN DRAGON 1 5.06 0
000726 LTTC 1 7.194 0
000779 SANMAO-
PAISHEN (2008ST)
1 3.954 0
000976 CHGF 1 1.082 0
000982 ZHONGYIN
CASHMERE(2008ST)
1 31.911 0
000803 JYAC 0.793 4.938 -5.286
000036 UDC 0.53 10.782 -8.225
200160 DALU-B (2008ST) 0.337 23.563 -8.349
000810 CRJH 0.713 3.96 -10.165
000955 XLKG 0.581 6.424 -11.227
000971 HB MAIYA(2008ST) 0.417 11.504 -12.153
000045 STHC 0.784 1.231 -22.385
000809 JOINT-WIT MEDICAL 0.652 2.256 -23.657
000158 CSTEX 0.491 1.17 -88.636

84 83 83

000971 HB MAIYA (2009ST) 0.402 6.854 -12.666
000810 CRJH 0.582 1.697 -17.116
000982
ZHONGYIN
CASHMERE 0.353 5.449 -20.69
000809 JOINT-WIT MEDICAL 0.592 1.009 -26.62

In 2007, there are 3 ST companies of the selected 17
textile companies, 000982 ZHONGYIN CASHMERE,
000681 FAR EAST STOCK CO.LTD, and 000779
SANMAO PAISHEN. Therefore, the number of sample
calculating default point is 3. Table 4.1 shows results of 17
company's default distance, of which three ST companies
DEA value reach the maximum 1, that is, the credit level is 1,
but the standard deviation of Rate of Return on Common
Stockholders Equity is large, that is, the volatility of
corporate profitability is very large, so the 3 companies
continues to be ST in 2008. 000018 VICTOR ONWARD is
classified as ST shares due to the same reason. It is
reasonable that 200160 DALU-B and 000971 HB MAIYA
is also assigned to ST category in 2008 because of their low
level credit and large volatile profitability .Other companies
were normal because there credit level is 1 or near 0.6 and
earnings volatility is small in 2008. In summary, it is
combining DEA and the quarterly standard deviation of Rate
of Return on Common Stockholders Equity, but not just
sorting default point, can reflect the true credit risk of the
company effectively.
In 2008as DALU-Bs missing data, there are 5 ST
companies, respectively 000982 ZHONGYIN CASHMERE,
000971 HB MAIYA, 000018 VICTOR ONWARD,
000681FAR EAST STOCK CO.LTD, 000779 SANMAO
PAISHEN, of which 3 ST companies DEA value is 1 and
default distance is positive, but still be ST in 2009. 00971
HB MAIYA still be ST in 2009 as its DEA value is 0.402
and default distance is negative. Comparatively, 00982
ZHONGYIN CASHMERE was finally normal, but its DEA
value is 0.352, the smallest of the sample, and default point
is second smallest of the sample.000036 UDC and 000712
GOLDEN DRAGON are classified to ST category due to
their large profitable volatility. In summary, it neither fully
reflects the difference between the ST companies and the
normal, nor accurately predicts the credit risk of listed
companies in China just according to default distance.
From the data of ST companies in 2007 and 2008, we
can conclude that default distance does not explain the
relative credit risk of the company well resulting from their
large DEA value and high credit level. The irrational results
are caused by the follow reasons: firstly, some data is
missing or inaccurate in some companies financial report.
For example, the short debt of 000018 VICTOR ONWARD
is 0 in 2007, the data of 200160 DALU-B is not incomplete.
Secondly, the selected sample is not reasonable enough; the
gap of some indicators is very large. Such as the receivable
turnover ratio of 200160 DALU-B is 0.7 in 2007 while the
number is 91.38 from 000976 CHGF. It makes DEA value
unreasonable indirectly. Other factors making default
distance reflect credit risk not well include: there is few ST
companies in the sample, then, it is not objective to compute
default point, that is ,the sample size making default point
difficult to reflect the industry level. it has little effect on the
sort of companies, but the number of companies with
negative default distance will change greatly.

IV. CONCLUTION
The results of this study show that: Although the
theoretical results using DEA method to calculate the default
distance does not match the actual situation, it still has
research value as a discussion of method, especially there is
not a kind of effective means to measure the credit risk of
the debtor.
From the results, experience, and method in the
empirical ,I think results will be better if doing some
improvement and try in the model as follows: First of all,
enlarging the number of samples, especially increasing the
number of ST companies, which make the default point
objective, scientific, and fair . Secondly, we should eliminate
the industry differences, seasonal differences of selling
products and make sure data maintaining integrity relatively
when we select samples. Finally, DEA method has been
developed and improved perfectly in the past 30 years; there
are also other comprehensive models, such as FG, ST,
Logistic DEA model, stochastic DEA model, and inverse
DEA model which also can be tried for research of default
distance.
ACKNOWLEDGEMENT

The paper is supported by the National Natural Science
Foundation (70871055); the New Century Talents plan of
Ministry of Education of China (NCET-08-0615); the Key
Programs of Science and Technology Department of
Guangdong Province (2010B010600028)


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