PREDICTION OF BANK FAILURES

PAUL A. MEYER AND HOWARD W. PIFER*

IN A FULL-EMPLOYMENT economy a firm's bankruptcy is prima facie

evidence of resource misallocation. This is not to say, however, that the
authorities should adopt every policy which minimizes bankruptcy. Fostering
monopolies to reduce failures, for example, only increases the misallocation of
resources. In one sense bankruptcy is desirable for it prevents further losses. But it
is nevertheless true that a change of policy, voluntary liquidation, or any other
method of eliminating losses at an early date would be preferable to bank-ruptcy
from both a social and private viewpoint. Predicting failures, due to whatever
cause, reduces the length of time losses are incurred and the mis-allocation of
resources.
The following section briefly discusses the causes of bankruptcies. Section
II presents the empirical results. To screen potential failures from viable firms,
we calculated regression equations in which the regressand is dichoto-mous and
the regressors are the value and trend of selected balance sheet and income
variables. The regressions differ in the number of independent variables and in the
lead time of the data to failure. The regressions are significant though, as
expected, their explanatory power is negatively related to the time period the data
lead bankruptcies. Section III demonstrates the ability of these functions to
classify solvent and closed firms and to predict the proper clas-sification of a
randomly selected holdout sample. We also illustrate how effi-cient regulatory
policy should be formulated.
While the techniques used in this paper could be applied to an analysis of
bankrupt firms in any industry, our sample industry is banking;' The sample is
particularly appropriate for two reasons. First, since defalcation explains a
substantial proportion of bank failures in the post-World War II period, the
banking industry provides an especially strict test of the predictive value of
financial ratios, as will be explained more fully in Section V· 3 Second, federal
* The authors are, respectively, Associate Professor of Economics, University of Maryland, and
Assistant Professor of Business Administration, Harvard University. The paper was written while both
authors were with the Federal Deposit Insurance Corporation; Meyer was a Brookings Economic Policy
Fellow at the FDIC. The authors are. deeply indebted to Robert Harris for making the data available and
to Stanley Silverberg for helpful suggestions. The authors alone are responsible for the conclusions, which
do not necessarily reflect the views of any organization.
1. Throughout this paper, the terms "bankruptcy," "bank closing," and "bank failure" will be used
interchangeably. Lack of data for uninsured banks forces their exclusion in the analysis.
2. Since defalcations are involuntary transfers, they, like other causes of failures, produce a social loss.
One person loses while the gain of embezzlers and other criminals are not income in a national accounting
sense. For a different explanation of the social loss incurred from crimes, see
[2].
3. As our study neared completion, Altman [1] confirmed our belief that the predictive value of financial
variables is enhanced when the sample firms failed for reasons other than embezzle-ment. His sample was
manufacturing corporation. none of which we suspect failed due to em-bezzlement.

853
854 The Journal of Finance

and state agencies already examine financial institutions to assure, among other
things, their solvency and viability. This examination procedure is somewhat
costly because the quality of individual loans has to be evaluated. We will show
how the solvency of a considerable number of banks can be ascertained and the
examination process improved using readily available balance sheet and income
data.
I. CAUSES OF BANK FAILURES

An exegesis of the voluminous prewar literature on bank closings is inap-

propriate largely because few studies were able to ascertain the specific
characteristics differentiating operating from closed banks.' For example, after
considering balance sheet levels, ratios, and year-to-year changes between 1921-
1933, Secrist [9] concludes that common a priori standards (for ex-ample, a ten
per cent capital-deposit ratio) cannot segment closed banks from viable
institutions. Though simple balance sheet relationships cannot dis-criminate, he
suggests that one could differentiate among banks by using more sophisticated
multivariate analysis.
Multiple discriminant analysis is a statistical technique used to determine the
variables that distinguish several a priori groups and to classify observa-tions
into one of these groups. However, if only two groups are relevant (for example,
solvent and failed banks), a regression function which constrains the dependent
variable to the values {O,l} can replace discriminant analysis. Though the
distributional assumptions and derivations of regression and dis-criminant
analysis are quite different, the results of the two methods are
Identical,"
Our choice of independent variables in Section II will be made clearer by
considering first some properties of regression equations when the de-pendent
variable is a dummy and then the causes of bank failures. To de-termine the
probability of failure we estimate the function (in matrix notation)
y = X~ + E, where Y equals one for failed banks and zero for solvent banks, and
XI is a financial variable. The expected value of Y is interpreted as the
conditional probability, given the X's, that failure occurs. Ceteris paribus,
_.f _ -f_8
the sign of (XI - X1)-where XI and XI are the means of XI for failed and solvent
banks, respectively-determines the sign of ~i. The t-value of ~I equals the ratio of
the difference in the mean of XI between bank classes to the sum of the within-
class variance of XI. Speaking loosely, if the XI for the two classes of
observations are from populations with quite different means and small
variances, then ~I will be significant.
The factors explaining bank failures may be divided into four groups: (1) local
economic conditions, (2) general economic conditions, (3) quality of
4. Some of the earlier studies are [5], [10], and [11]. More recent investigations of the same period
include [3] and [4].
5. For a comparison of these statistical techniques, see [8J. Though we treat the estimates as
regression equations, we nevertheless believe that the distributional assumptions of discriminant analysis
are more appropriate in this case. Consequently, we ignore Goldberger's [6, pp. 248-257] valid
observation that a regression equation with a dummy dependent variable violates the classical least
squares assumption of homoskedasticity.
 Prediction oj Bank Failures 855

management, and (4) integrity of employees. Most banks are local institu-tions.
Except for a few banks in large cities, a bank's service and loan mar-ket area
encompasses at most the counties in which the bank's offices are located and
contiguous counties. Although the parts and their sum are posi-tively correlated,
local rather than national well-being is the better determi-nant of demand for
many banks' output and, ceteris paribus, their success or failure. Banks situated in
high income and growth rate areas are less likely to fail." Any measure of local
economic conditions must also consider the structure of the local banking industry
and the availability of banking substitutes. While few if any banking markets are
competitive, the degree of monopoly is not constant.
To estimate the effect of local conditions, the regressors would ideally include
local variables, and the sample of solvent firms would be random with respect to
local conditions. Unfortunately, the data necessary to ade-quately measure local
conditions are not available. Consequently, each failed bank is "matched" with a
comparable solvent bank. The requirements for being comparable, in order of
importance, were that the banks (a) were in the same city, or in the case of a one-
bank town, in the same economic area,
(b) were approximately the same size and age, and (c) had the same regula-tory
requirements. Data for a solvent bank cover the same period as its matched closed
bank. Given this control sample of solvent banks, even if local economic data
were reliable, the local variables would be equal for the two classes of banks and,
therefore, their coefficients would be insignificant. While second best,
standardizing for local economic conditions in this fashion is preferable to
selecting a random (nonmatched) sample of banks with local variables omitted.
Since standardizing for local economic conditions requires not only that the
banks be similarly situated but also that the data for solvent and closed banks
cover the same period, our previous discussion indicates that general-economic-
condition variables would be insignificant in this case and are not included in
subsequent analyses. The last sentence is not incompatible with our conviction
that depressions and the forced sale of assets to meet reserve requirements and
currency drains can easily topple a bank with an ex ante sound portfolio, as the
1920's and 1930's demonstrate,"
While the first two factors contributing to failures are largely exogenous to the
individual bank, the endogenous variables are the quality of manage-ment and
honesty of employees. The importance of management in the sue-

6. For eight of the nine banks that failed between 1959-61, "income" in the counties where the failed
banks were located increased 75.2 per cent between 1949-59. The average increase in the U.S. was 116.9
per cent. "Income" was computed by multiplying median income per family and the number of families.
The paucity of county 'data forced this definition of income and the time period. For one county in which a
failed bank was located, income could not be estimated. U.S. Bureau of the Census, County and City Data
Book 1965, U.S. Government Printing Office, 1967, and ibid., 1962.
7. In other words, if each bank class were randomly selected, the failed bank group would contain
.many more observations from the prewar period than the solvent bank group. Then general economic
variables should be included because the means of these variables would differ between bank classes.
However, our samples are not random. The means of general economic variables are necessarily equal
when the data for both bank classes cover the same period.
856 The Journal of Finance
cess or failure of the firm is obvious. Managerial ability is like Lord Acton's
elephant-difficult to define but easy to identify. Over a period of time, dif-
ferences between good and poor management will be systematically reflected by
balance sheet and income data, and analysis of such data should enable prediction
of failures.
As important as management in explaining recent failures is the honesty of
employees. According to FDIC Annual Reports between 1948 and 1965, financial
irregularities contributed to at least one failure in each year. There-fore, an
objective measure of honesty would significantly discriminate be-tween potential
failures and sound banks. Though such a measure does not exist, all is not lost
because defalcation usually occurs over a long period of time and must affect
several balance sheets and income statements." Defalca-tions over several years
(in spite of double-entry bookkeeping, the stock-flow relationship between the
balance sheet and income statement, and well-trained examiners) attest to the
diverse and cunning methods taken. Given this and the importance of defalcation
in explaining bank failures, our sample provides an especially strict test of the
discriminatory and predictive power of financial variables.
In short, this study attempts to discriminate between bankrupt and solvent
banks that face similar local and national market conditions. We determine
statistically the financial variables that mirror managerial ability and em-ployee
honesty, distinguishing solvent banks from failures due to poor man-agement
and/or defalcation.
II. THE DATA AND EMPIRICAL RESULTS

Our objective is not simply to explain previous failures but, more impor-tantly,
to predict (future) failures. Given the poor quality of prewar micro-banking data
and our belief, which needs no elaborate defense, that the events of the 1920's
and 1930's will not be repeated, our sample includes only banks that closed
between 1948 and 1965 and similarly situated solvent banks. During the period,
55 insured banks closed, 39 of which were included in this investigation. Closed
banks had to satisfy two criteria for inclusion in our sample. First, since complete
data for six years prior to bankruptcy were considered necessary, banks in
existence for less than six years as well as banks with incomplete records were
excluded," Second, as previously stated, a comparable solvent bank was required
for each closed bank. The number of paired banks which met these requirements
were then randomly divided into an original sample of 30 pairs and a holdout
sample of nine.
The data for each reporting period (or calendar year) came from three sources.
The first two were the year-end balance sheet (Report of Condition)
8. The Sheldon (Iowa) National Bank case received much attention not because the embezzle-ment
went undetected for thirty years but because of the embezzler's generosity. "[The embezzler] could
always be counted on to help a needy friend or befriend a deserving cause. It seemed as if half the folks in
Sheldon could have testified to her generosity." Time (July 8, 1966), p, 20. Though far from complete,
long-time defalcations are also noted in The Houston Post, December 5, 1959, p. ], and New York Herald
Tribune, October 8, 1957, p. 1.
9. We begin our study of postwar closings in 1948 because of our data requirement and the significant
revisions in the 1942 reporting forms.
 Prediction of Bank Failures 857
and income statement (Income and Dividend Report). The third was the summary
of the examination report (FDIC Form 96). While the bank ex-amination process
estimates the quality of bank loans and yields other useful information, the timing
of such examinations is uniformly distributed through-out the year. The financial
information was summarized into 28 operating ratios and 4 balance sheet levels,
thus eliminating scale effects from most of the variables. Some but not all
correspond to ratios considered in previous studies of bank failures and hopefully
measure bank performance.'?
Each of the 32 financial measures took several forms. Assuming that failure
occurs at time t = 0, data were collected for the six years prior to closing (t = -6,
-5, ... , -1). Given that the likelihood of failure is detected at t = T < 0, the forms
selected for each operating ratio and balance sheet level were:
=
X(i)T the value of the it h variable at time t T, =
X(ih-l - the variable's value in the previous year,
~(i) = the annual rate of "growth" of the variable in the years prior to
detection,
X(i)T - X(i)T = the error in predicting the value of the variable in the year of
detection, and
COV(i) = the "coefficient of variation" (the standard error of the estimate
divided by the mean level), a measure of vari-ability,

where X(ih,~(i), and the standard error of the estimate are from the least
squares equation of XCi) on time. That is, X(ih = a(i) + ~(i) t, t = -6,

... ,T - 1, and X(ih = a(i) + ~(i) T is the predicted value of X(ih. Thus, for each
financial measure there are five variables that summarize the levels, trend,
variability, and unexpected deviation. In the following regressions, lead time
between detection and failure is varied by altering T in the above formulations.
The regression results are presented in Tables 1 and 2. To repeat, the dependent
variable equals one for closed banks and zero for solvent banks, and the
regressors are financial variables. We used a stepwise regression program which
combines forward selection with backward reduction at each step. That is, the
variable entered on each iteration is that which, combined with previous variables,
minimizes the residual sum of squares and satisfies a prespecified minimum F-
value. Although the contribution of an entering variable is contingent upon those
previously selected, a variable is deleted at a later iteration if its individual
contribution falls below a minimum F-value.
Table 1 assumes that detection occurs one year prior to failure, i.e., the data are
derived from financial statements up to one year prior to bankruptcy (T = -1). For
example, if the bank failed on July 15, 1961, the most recent data are up for the
year ending December 31, 1960. Of course, data further
10. A somewhat longer version of this paper, which is available from the authors on request, describes
the statistical techniques in more detail and lists all the financial measures.
 00
til
00

TABLE 1
PARAMETER ESTIMATES FOR ORIGINAL SAMPLE IN ORDER OF ENTRY IN STEPWISE PROCEDURE, By NUMBER OF INDEPENDENT VARIABLE IN
REGRESSION EQUATION
(Data Up to One Reporting Period Prior to Failure)
Correia tion
~
Ranking
X2 X4 X5 X6 X7 X9 X Cll

Number of tlo Xl Xa Xs lO R2 ;:;-

Variables 1 5 17 12 18 108 126 98 15 23 (F-Ratio) ~

5 .891 .013 :004 .001 -.004 -.084 .569 t:l....

(1.98) (3.02) (2.16) (2.00) (1.70) (5.16) ~

6 .882 .017 .005 .001 -.004 -.117 -.050 .615 ~
(2.49) (3.27) (2.08) (2.26) (2.33 ) (2.17) (5.38) ;!'
7 .953 .021 .005 .002 -.004 -.138 -.053 -.018 .656
t:l
;;t
(\
(3.07) (3.58) (2.61) (1.90) (2.78) (2.39) (2.18) (5.61) Cll

8 1.218 .021 .005 .002 -.004 -.122 -.064 -.024 -.016 .696
(3.22) (3.70) (3.47) (2.29) (2.53) (2.93) (2.83) (2.30) (5.98)
9 .871 .016 .005 .002 -.128 -.084 -.025 -.022 .168 -.328 .741
(2.53) (4.23) (3.76) (2.77) (3.80) (3.10) (3.01) (2.44) (2.37) (6.77)
 TABLE 2
PARAMETER ESTIMATES FOR ORIGINAL SAMPLE IN ORDER OF ENTRY IN STEPWISE PROCEDURE, By NUMBER OF INDEPENDENT VARIABLE IN
REGRESSION EQUATION
(Data Up to Two Reporting Periods Prior to Failure)
~
(\)...
Correlation I:l

<'\....
Ranking
x, X R2
Number of Xl Xa X4 X5 Xa X7 Xs Xg lO c:.
;:I
Variables ~o
1 12 7 8 37 9 3S 19 26 20 (F-Ratio)
~
5 1.099 .040 .005 - .004 -.019 .002 .596 b:l
(2.90) (2.80) ( 2.13) (2.76) (3.04) (5.96) ~
;:I
6 1.057 .042 .005 - .004 -.023 .002 .001 .642 ~

(3.14) (3.08) ( 2.23) (3.32) (3.22) (2.25) (6.18) ':r.l

~
7 1.198 .040 .005 - .005 -.024 .002 .001 -.069 .671 ~
(3.12) (3.05) ( 2.64) (3.56) (3.15) (2.14 ) (1.90) (6.08) ...
~
8 1.009 .044 .005 - .004 -.023 .002 .001 -.075 .037 .692
(3.40) (3.02) ( 2.17) (3.41) (3.20) (2.38) (2.09) (1.67) (5.85)
9 1.047 .043 .005 - .004 -.024 .002 .001 -.072 .036 -.245 .709
(3.41 ) (2.79) ( 2.21) (3.61) (3.34 ) (2.35) (2.04) (1.65) (1.58) (5.63)

00
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860 The Journal of Finance

in the past (from 1955) are also used to compute growth and coefficient of
variation variables. The parameter estimates in Table 2 correspond to T = -2, or
anticipating future notation, 't = ITI = 2, where 't is the lead time be-tween detection
and subsequent failure. In both Tables the number of indepen-dent variables varies
from 5 to 9. Addition of variables usually increases the explanatory ability of an
equation but also increases data collection costs. Other reasons for presenting
equations with alternative numbers of indepen-dent variables will be clear after the
next section, where the concept of prediction cutoff levels is discussed.
For each variable we present the regression coefficient and t-value in paren-
thesis. R2 and F-statistics are also given. Regardless of the number of vari-ables,
the F-value of the equations in both tables is significant at the one per cent level.
For 't> 2, however, the regressions were insignificant and are not presented. For
small numbers of independent variables (5 - 7) the mul-tiple correlation
coefficients are greater in Table 2 than 1, and the converse holds for large
numbers of variables. The number immediately below the XI variables (which
will be identified shortly) is the rank from high to low of the absolute value of its
simple correlation with the dependent variable. Re-calling that the total number
of variables was 160 (32 financial measures with five forms each), an heuristic
method of data selection probably would have ignored some of the variables
chosen by the stepwise method.
The sign of each variable is invariant to the other variables included; neither
Table 1 nor 2 contains a sign reversal. Indeed, the coefficients are strikingly
stable. The coefficients of X, in Table 2, for example, are the same in all
regressions. The stability of the coefficients enhances confidence in the
importance of a few not obvious variables and in the appropriateness of some
signs. The t-values of all coefficients are at least one since the cutoff for entry
and exit of a variable was a marginal F -value of one.
We shall explain the sign and significance of the variables in Table 1 first and
then Table 2. The sign of most variables corresponds with a priori expec-tations
and little discussion is necessary. The sign of some variables can be explained
only when one considers the other variables and the order in which they are
included. In virtually all cases the partial correlation is greater than the simple
correlation.
X I = Error in predicting Cash and Securities/Total Assets at year t = -1. The
ratio of cash and securities to total assets is a measure of current liquidity, and Xi
indicates the unexpected or unpredicted change in liquidity. The coefficient is
positive and significant at least at the 5 per cent level, which indicates that,
ceteris paribus, the value of X, is significantly greater for closed banks than
solvent banks. The greater is Xi and the shortfall in liquid-ity, the greater is the
estimated value of the dependent variable and, conse-quently, the probability of
failure. Note again that it is not the actual liquidity level that matters but the
unpredicted change in liquidity.
X 2= Coefficient of Variation in Rate of Interest on Time Deposit. The coefficient is
positive and generally significant at the one per cent level. The importance of this
variable probably does not come to mind immediately. Since neither the level nor trend
of time deposit rates is significantly different
 Prediction of Bank Failures 861
between closed and operating banks, the greater variation of rates by closed banks
perhaps manifests instability of objective or goal.
X 3 = Time/Demand Deposit Ratio in year t = -2. The coefficient is posi-tive
and significant at the five per cent level or better. The often-alleged dif-ference in
costs of demand and time deposits explains the positive relation between this
ratio and the likelihood of failure.
X 4 = Operating Revenue/Operating Costs in year t =
-1. Clearly the sign
should be negative-the more profitable a bank today, the lesser the likelihood of
failure tomorrow. If the variable is not as significant as one would expect, it
undoubtedly is because of the importance of defalcation.
X lO = Operating Income/Total Assets at year t = -2. A priori, the choice between
X lO and X 4 as measures of profitability is difficult. When X lO enters, X 4 drops out.
Though the income/asset ratio at t = -2 does better than the ratio at t = -1, the
difference is virtually inconsequential.
X 5 = Growth of Consumer Loans/Total Assets. The coefficient is negative and,
except for the equation with five variables, significant at the five per cent level.
Particularly up to the 1950's, this variable may have been a proxy for the quality
of management. After a long tradition of concentrating on short-term business
loans, consumer loans increased markedly during the postwar period. The
consumer loan/total assets ratio increased more in aggressive well-managed
banks than in closed banks.
X 6 = Growth of Cash and Securities/Total Assets. This variable is closely
related to Xi. The coefficient is negative, indicating that X 6 was less for failed
than solvent banks. The relative liquidity position of failed banks decreased
significantly (at the five per cent level) over time.
X 7 = Coefficient of Variation of Total Loans. Well-managed banks do not
religiously follow rules-of-thumb such as loans should equal 60 per cent of assets.
These banks adapt to market conditions and alter the structure of their portfolio.
Consequently, X 7 is significantly negative at the five per cent level or better.!'
X s = Real Estate Loans/Total Assets at year t = ....:... 1. The coefficient of
Xs is significantly negative for two reasons. During the period 1948-65 the
default rate on real estate loans was quite low, and rising property values assured
small losses on foreclosures. It appears ex post that banks over-estimated the risk
premium on real estate loans, and consequently these loans were quite profitable.
Second, posting loans to nonexistent individuals or corporations is a common
method of defalcation. Since legalities increase the probability of detecting
counterfeit real estate loans, other types of loans are more likely to be counterfeit.
Given the importance of defalcations in explain-ing failures, the sign of X, is as
expected.
X 0 = Fixed Assets/Total Assets at year t = -2. The coefficient of X o is
11. Some may feel that we are guilty of ex post rationalizations. The variation of time deposit rates
demonstrates poor management while the variation of total loans demonstrates good manage-ment. Of
course we did see the sign of a coefficient before we explained it. Signs need not be obvious; they only
should not be a priori unreasonable. While few variables are truly exogenous, we may think of total assets
as exogenous. It is unreasonable to hold that instability, which fluctuating (exogenous) total assets attest,
reduces the probability of failure. However, X 7 is loans, an endogenous variable in our minds-even
before this study.
862 The Journal oj Finance

significantly positive. Each bank needs a certain amount of fixed assets. Suc-
cessful banks combined these fixed assets with an adequate volume of "earn-ing"
assets. Unsuccessful banks did not and hence had insufficient earnings to stay
alive. Moreover, a high ratio of fixed to total assets reduces the flex-ibility of
balance sheet adjustments and increases the probability of bank-ruptcy.

The variables in Table 2 are also numbered X1-X lO • It would be sur-prising if

the set of variables distinguishing solvent banks from banks that will fail within
the year is identical to the set distinguishing solvent banks from banks that fail
two years hence. On the other hand, at least a few variables should be identical
since some factors leading to failure are of a long-run nature. Approximately half
of the variables in Table 1 and 2 are similar and their signs will not be explained.

Xl = Growth of Indebtedness of Directors, Officers, Employees (DOE) and

Affiliates/Total Capital. A large increase in the DOE loans/capital ratio may be a sign
of poor management (at best) or embezzlement (at worst). A few DOE view a bank's
resources as a means of financing their other invest-ments. Loans to these DOE are
more risky than loans to outsiders, given equal terms on both types of loans. Indeed,
for some, but certainly not all, DOE loans the distinction between speculative and
counterfeit loans is blurred. The significantly positive coefficient implies the DOE
loans/capital ratio of failed banks grew more rapidly.
X 2 = Time/Demand Deposits at t = -3. This variable entered on the second
iteration but was subsequently deleted when X6 entered.
X 6 = Time/Demand Deposits at year t = -2.
X 3 = Coefficient of Variation in Rate of Interest on Time Deposits.
X 4 = Operating Revenue/Operating Cost at year t = -2.
X 5 = Real Estate Loans/Total Assets at year t = -2.
X 7 = Growth of Total Loans.
X s = Error in predicting Gross Rate of Returns on Loans at year t = -2. The
order of entry is important in explaining the signs of X 7 and Xs, It is no
coincidence that the growth of loans is followed immediately by the error in
predicting rates of return. Apparently during the period ending two years prior to
failure, insolvent banks increased their loan portfolio relative to solvent banks by
lowering their credit standards and making high risk, high gross return loans.
Consequently, the signs of X 7 and Xs are significantly positive and negative,
respectively.P In the year prior to failure (t = -1) the policy of loan expansion by
quality deterioration was abolished. The validity of this explanation is supported
by the next variable to enter, Xe,
X 9 = Questionable Assets/Total Assets at year t = -2. The probability, as
estimated by bank examiners, of receiving the full face value of question-
12. At the risk of being prolix, the sign of X s is re-explained. Assuming independence, the sign of X s
is the same as the sign (P-A)f - (P-A>., where P and A are the predicted and actual gross loan rates
respectively, and subscripts indicate the class of bank. For simplicity, assume that (P-A) 8 =O. If the
actual gross rate on loans of failed banks is greater than the predicted rate, which is likely to be the case
when banks lower the quality of their loans, (P-A)f and, conse-quently, the sign of X s are negative.
 Prediction 0/ Bank Failures 863

able assets is relatively low. Though the criteria used to determine which assets
are questionable are not rigid but somewhat discretionary, most reason-able men
would endorse the evaluation of anyone examiner. Perhaps surpris-ing then is the
relative unimportance of this estimate of quality. The ratio of questionable to total
assets is significant only at the 10 per cent level, is the eighth variable to enter
(ignoring X2, which was eliminated), and is insignifi-cant in the year prior to
failure. Moreover, as we show in the next section, the equations with 5-7 variables
predict failures as well as the equation with 8 and 9 variables at most cutoff
levels.
XlO = Growth in the Net (after losses) Rate of Interest on Securities. The
coefficient is marginally negative. During a period of rising interest rates, solvent
banks increased the return on their security portfolio more than failed banks.

III. CLASSIFICATION, PREDICTION, AND THE CUTOFF VALUE

How well do the regression equations in Tables 1 and 2 classify the obser-
vations? Table 3 provides the percentage of errors in classifying the original
TABLE 3
PERCENTAGE OF ERRORS IN ESTIMATION OF ORIGINAL SAMPLE BY TYPE OF ERROR AT
ALTERNATIVE CUTOFFS, By NUMBER OF INDEPENDENT VARIABLES IN
REGRESSION EQUATION

(Data Up to One (Data Up to Two

Reporting Period Reporting Periods
Prior to Failure) Prior to Failure)
Number of Cutoff Values Cutoff Values
Variables .30 .40.50.60 .70 .30.40.50.60.70
5 Type I 3 17 27 37 70 27 40 53 70 80
Type II 60 40 23 13 0 30 17 3 0 0
6 Type I 7 13 20 37 57 30 40 53 67 73
Type II 57 30 23 7 0 30 10 0 0 0
7 Type I 10 13 17 33 50 27 33 43 63 73
Type II 47 33 20 10 0 20 7 0 0 0
8 Type I 7 13 20 30 33 27 27 40 50 63
Type II 40 27 13 7 7 20 3 0 0 0
9 Type I 3 7 10 23 33 23 23 43 57 63
Type II 37 20 13 10 7 20 7 0 0 0

sample by type of error at alternative cutoff levels. That is, the population of
Ycan be segmented into populations Y> Ye and Y< ye, where the cutoff Ye is
an arbitrary value a < Ye < 1. Since Y was specified as unity for banks which
closed and zero for viable institutions, the observation is correctly
classified if Y > YelY = 1 or Y < YelY = O. The two types of error that can
result are:

Type! Y<Ye!Y=l
Type II Y> Ye!Y =0
Type I errors occur when a bank which subsequently fails is predicted to be a
viable institution; Type II, whenever a solvent institution is assumed to be failing.
By construction, Type I and II errors are positive and negative func-
864 The Journal 0/ Finance
tions, respectively, of ye. Expressed in percentages, Table 3 gives the number of
errors by type divided by 30, the number of either closed or solvent banks in the
sample.
Temporarily ignore how one determines the appropriate cutoff value. As
expected, at most cutoff values the percentage of Type I and II errors is a
negative function of the number of variables." At ye = 0.5 and 1: = 1 (where
again 1: is the time interval the data lead failure), the average of Type I and
II errors with five explanatory variables is 25 per cent, which is significantly less
than the "chance" expected value of SO per cent. With nine explanatory variables,
12 per cent of the observations are incorrectly classified, or 88 per cent are
correctly classified.
The time pattern of the errors also corresponds with a priori expectations.
Given some number of variables and a cutoff value, Table 3 shows that the
percentage of Type I errors is greater with 1: = 2 than 1: = 1. For most failed
banks the estimated value of the dependent variable, or, equivalently, the
discriminant score fell as the lead time of the data to failure increased. Two years
prior to failure the discriminant score of most failed banks was lower (they were
more like solvent banks), and so at any cutoff the percentage of Type I errors was
greater for 1: =2 than 't =
1. Type II errors have the op-posite time pattern. The
discriminant score of most solvent banks is less the further in the future will a
near-by bank fail. Immediately prior to the failure
TABLE 4
PERCENTAGE OF ERRORS IN ESTIMATION OF HOLDOUT SAMPLE BY TYPE OF ERROR AT
ALTERNATIVE CUTOFFS, By NUMBER OF INDEPENDENT VARIABLES IN REGRESSION EQUATION

(Data Up to One (Data Up to Two

Reporting Period Reporting Periods
Prior to Failure) Prior to Failure)
Number of Cutoff Values Cutoff Values .70
Variables .30 040 .50 .60 .70 .30 .40 .50 .60
5 Type I 0 11 22 44 56 0 0 22 44 56
Type II 56 56 11 0 0 78 67 44 0 0
6 Type I 0 0 0 33 67 0 11 33 56
33
Type II 56 22 11 0 0 78 78 44 1111
7 Type I 11 11 22 33 44 0 11 33 33 56
Type II 22 22 11 0 0 78 67 22 11 11
8 Type I 11 22 22 22 22 0 0 22 33 67
Type II 22 22 11 11 11 89 78 56 22 11
9 Type I 0 11 ZZ 33 56 0 0 22 33 56
Type II ZZ 22 11 0 0 89 78 56 22 11

of a similarly situated bank, the factors which cause failure (such as local
economic conditions) also affect the solvent banks."
The ability to stratify past bank closing is an interesting, but academic,
13. This reflects the positive relationship between the number of variables and R2. Additional
regressors did not significantly decrease the sum of errors.
14. Since the dependent variable is the same irrespective of 't, the means for both bank groups cannot
be negatively related to 't, for the sum of the residuals must always equal zero. In a nontechnical manner
the text indicates that for both bank groups (1) the median of ? and 't are negatively related, and (2) the
second and third moments of the distribution of '9' are not invariant to 'to
 Prediction of Bank Failures 865

question. The value of the equations (hopefully) lies in predicting future failures.
Are the parameters, which were chosen to maximize the separation between the
sample groups, free of sample bias and, therefore, can the equa-tions predict
successfully? Predictive ability may be simulated by applying the equations of
Tables 1 and 2 to a random holdout sample, a realistic ap-proximation if general
economic conditions are stable. The percentage of er-rors in classifying a holdout
sample of nine paired banks is given in Table 4 for 't' = 1,2.
Again, the results are encouraging. The average percentage of errors in Tables 3
and 4 are not significantly different. With 't' = 1 and any number of explanatory
variables, at least 83 per cent of the holdout banks are cor-rectly classified at some
ye. The best results occur when six independent variables are included. With Ye =
0.5, the average of Type I and II errors is 5 per cent; all failed banks are correctly
classified, and only one solvent bank is misclassified. For 't' = 2, the number of
correct classifications decreases slightly. If the number of variables is seven or
less, 78 per cent of the banks are correctly classified; for more than seven
variables (when one variable is the questionable/total assets ratio determined by
current examination procedures) proper classifications number 72 per cent. Thus,
not only can one correctly classify more than 80 per cent of the original sample
but he can also predict the classification of a random holdout sample with
approximately the same accuracy.
Given the continued applicability of the parameter estimates (Tables 1-3), how
does one use these estimates? Statutes now, and we assume in the future as well,
require "on the spot" examinations of each bank." Our estimates, nevertheless,
could act as a screening device; Le., extra examination time and advice is
allocated those banks predicted to fail. Which banks are pre-dicted to fail, or what
is the appropriate cutoff level? Clearly, if detection of failures is the sole
objective, one selects a cutoff level that eliminates Type I errors. Unfortunately,
this leads to extremely high Type II errors since nearly all banks exceed the cutoff.
From both an economic and regulatory standpoint, a more efficient objective
would maximize the returns of applying the screening device. Returns (which may
be negative) arise from eliminating bank failures, harassing solvent banks
predicted to fail, etc. Given some r, the efficient policy maximizes R, the per bank
expected net return, with respect to y:where

R = P(s,S,.) (R(s,s,. + P(s,f,.) R(s,f,.) + P(f,f,.) R(f,f,.) + P(f,s,.) R(f,s,.) - E

(1)
and the events are defined as
=
S (y < Ye),
f= (y >Yc),
s,. = bank would be operating 't' years hence, assuming prediction per se does not affect
bank behavior,
f,. = bank would fail 't' years hence, assuming prediction per se does not affect
behavior,

15. The essence of the following discussion does not depend on the assumption, which only affects the
value of some functions to be introduced.
866 The Journal of Finance

and
s
P(S,Sr) = the joint probability that events and s, occur,
R(s,sr) = the net return of the joint event 5,Sr,
E =the cost of predicting, a constant.
A side restraint to (1) is max R > 0, for there exists the alternative of no
screening device.
Equation (1) can be simplified. Since those banks predicted to succeed would
be dropped from further consideration, and only those predicted to fail would be
further examined and aided, the first two terms in (1) vanish. There can be no
return from predicting a success or a failure if the prediction is pocketed and not
acted upon." Since predictions of failure are acted upon, a non-zero return may
occur in these cases. While costs are always incurred in further examining and
aiding any bank predicted to fail, a positive net return will be gained in some
cases. Though it is impossible to prove or cite specific cases, classifying a bank
as a "problem" and subjecting it to special scrutiny often improves profits and
avoids failure. We assume that the extra costs of "turning around" a bank that
would have failed are well spent; the extra costs, in fact, prevent the failure and
lead to a positive net return. Let Ref, fr) = 31:1 C(f) > 0 where C(f) is the cost of a
failure and 0 < 31:1 < 1,17 While some value may be gained from aiding
(harassing) those predicted to fail who would have succeeded anyway, the net
return is negative. Let R(f, s-) = - 31:2 C(f), where 0 < 31:2 < 1.
The optimal policy, given some 1', then is that Yc maximizing"
3I:1P(Lfr) -3I:2P(f,sr) . (2)

Employing Bayes Theorem and recalling that P(Sr) + P(f-) = 1, (2) be-comes
31:1 p(fffr) (1 - P(Sr» - 31:2 P(ffSr) P(Sr). (3)

The conditional probabilities can be obtained from Table 3. 19 P(ilsr) is the

16. Of course, a failure, whether predicted or not, indicates a negative social return. However, there is
no negative return from predicting success when in fact failure occurs. The prediction of success per se

does not cause failure. The same incorrect reasoning that suggests R(;, f r) is negative also suggests R(;,
sr) is positive because the extra examination costs are avoided by correct pre-dictions.
17. Though some may like to think of a cost as a negative return, C(f) is defined to be positive, so R(t,
fr) > O.
18. The optimal Yc is independent of C(f) and E, which are relevant only in determining if the side
restraint R > 0 is satisfied.
19. Of course, our recent estimites could not have affected the failures and successes of several years
past, so Table 3 does provide the conditional probabilities. However, one problem does arise. Least
squares minimizes the sum of the squared errors irrespective of the type of errors. For use in a screening
procedure, the conditional probabilities generated by least squares may be inappropriate if 11: 2 and 1-11:1
are not equal. If 11: 2 does not equal 1-11: 1 (as may well be true), the conditional probabilities might better
be generated by a statistical technique that minimizes the sum of weighted errors, where the weights are
related to 11:1 and 11:2, This suggests a pattern classification algorithm with a priori weights. See [7]. At
this time we feel compelled to only note the implicit assumption about ~ and 11: 2 embedded in the
conditional probability estimates of Table IV.
 Prediction of Bank Failures 867
percentage of Type II errors and P (£1 f-) is one minus the percentage of Type I
errors. Since :Itt, :lt2 and P (ST) are independent of ye, from our previous dis-
cussion the first term is a negative function of ye, and the second term (with the
minus sign) is a positive function. Consequently, the Y« maximizing (3) need not
be an extreme value minimizing either Type I or II errors.
The optimal Ye depends on the parameters :Itt, :lt2 and P(ST), which are
unknown. The unconditional probability estimate depends upon forecasted
general and local economic conditions, which have been standardized in this
study. Nevertheless, one may and should subjectively estimate the para-meters
and solve (3). While the optimal Ye is somewhat arbitrary and subjec-tive, we at
least know that (optimal yel.= 1) > (optimal yel.=2). This is so because, though
not written explicitly in (3), :Itt is positively related to "'-the sooner a potential
failure is detected, the more that can be done to avoid failure and the greater is the
return."
While we shall refrain from revealing our estimates of the parameters in
(3) , such somewhat arbitrary estimates cannot be avoided." Perhaps because of a
desire for objectivity, the value of a discriminant function is often mea-sured by
the proportion of Type I and II errors, and Ye is chosen to minimize
the sum of the estimated PcflsT) and P(slfT).22 This decision rule is easy to
follow but, in explaining successes or failures in any industry, patently in-correct.
The rule implicitly equates the (negative) return of each type of error and lets the
return of correct predictions be zero." Nevertheless, were the rule followed, as is
often the case, (Yel. = 1) = 0.50 and (yel. = 2) = 0.40. These discriminant
functions would correctly classify approximately 85 per cent of the observations.

IV. CONCLUDING REMARKS

This paper is largely empirical. Theories of the growth or decline of a firm are
not presented. Previous studies suggest that a simple analysis of financial
variables which readily come to mind will be unable to discriminate among bank
groups. Rather than mining the data for confirmation of specific hy-potheses, we
have chosen to include many variables in several forms, some obviously
important and some not so, and let the data speak for themselves. Two main
conclusions follow. First, even when failure frequently results from embezzlement
and other financial irregularities, financial measures can evalu-ate the relative
strength of firms. With a lead time of one or two years, approximately eighty per
2
cent of the observations are correctly classified, and the R is about 0.70, quite
high for a cross-section study. When the lead time is three years or more,
however, financial variables are unable to discriminate between viable and failing
banks. Thus, a screening procedure based on our
20. We are implicitly assuming here that the probabilities are independent of 'f.
21. Even if regulatory authorities wanted to use the proposed screening procedure, it probably would
become ineffective upon disclosure of the parameters, given the importance of embezzlement as an
explanation of bank failure.
22. See, for example, [1, p. 599].

23. [8, pp, 876-77]. In some problems, e.g., classifying a student in ability groups, these assump-tions
may be valid and the rule yields the optimal Ye.
868 The Journal of Finance
results could provide up to a two-year period for correction of impending
bankruptcies. Second, much more than the current financial position is needed to
discriminate among bank groups. For example, with nine variables in Table 1,
only one variable is a financial ratio at the end of year prior to failure, and eight
variables measure trends, variation, unexpected changes, and values two years
prior to failure.
Since the value of correct predictions to private investors is obvious, we have
emphasized social values and regulatory policy. Ceteris paribus, an individual
would invest in those institutions with the smallest discriminant score. The
previous section illustrated a screening procedure that allocates extra examination
resources to the predicted bankruptcies. If for any reason one does not wish to
specify a cutoff value and designate some banks as potential failures, the
authorities like private investors could make decisions based on the ranking of
the dependent variable. Rather than thoroughly examine approximately 13,000
commercial banks in an essentially random order, the estimated dependent
variable could be used to sequence examina-tions. That is, each bank in effect
could be pre-examined when annual operat-ing reports are submitted, often
within a month following the end of the period. The insignificance of variables
taken from the summary of examina-tion form in the year prior to failure makes
the timing of this screening process feasible. Strong institutions would be
segmented from the weak. The latter would at least be examined first and,
perhaps, more carefully. Success in this endeavor should decrease the number of
failure while strengthening the marginal institutions.
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(March-April, 1968), 169-217.
3. R. V. Cotter. "Capital Ratios and Capital Adequacy," National Banking Review (March, 1966), 333-346.

4. A. H. Cox Jr. Regulation of Interest Rates on Bank Deposits. Michigan Business Studies, Vol.
XVLL, No.4, 1966.
S. Fred L. Garlock. Country Banking in Wisconsin During the Depression. Washington: U.S.
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6. A. S. Goldberger. Econometric Theory, New York: John Wiley and Sons, 1964.
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