Model Answer for Chapter 10: Logistic regression.

Problem 10.1 (8.1 in 1st edition)

8.1 Financial condition of banks: The file Banks.xls includes data on a sample of 20 banks.
The “Financial Condition” column records the judgment of an expert on the financial condition of
each bank. This dependent variable takes on one of two possible values – “weak” or “strong” –
according to the financial condition of the bank. The predictors are two ratios used in financial
analysis of banks: TotLns&Lses/Assets is the ratio of Total Loans & Leases to Total Assets and
TotExp/Assets is the ratio of Total Expenses to Total Assets. The target is to use the two ratios
for classifying the financial condition of a new bank.
Run a logistic regression model (on the entire dataset) that models the status of a bank as
a function of the two financial measures provided. Specify the “success” class as “weak” (this is
similar to creating a dummy that is 1 for financially weak banks and 0 otherwise), and use the
default cutoff value of 0.5.

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Answer to 10.1.a:

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(i) The logit as a function of the predictors:
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Answer to 10.1.a.i:

Refer to the “LR_Output1” sheet in 10.1_Banks.xls

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Output:
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The Regression Model

Input variables Coefficient Std. Error p-value Odds

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Constant term -14.7209597 6.67487764 0.0274241 *

TotExp/Assets 89.83362579 47.78068924 0.06009115 *
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TotLns&Lses/Assets 8.37129402 5.77879238 0.14744277 4321.222656

logit =-14.7210 + ( 89.8336 * TotExp/Assets) + (8.3713* TotLns&Lses/Assets)

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(ii) The odds as a function of the predictors:

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Answer to 10.1.a.ii:
Odds = e(-14.7210 + ( 89.8336 * TotExp/Assets) + (8.3713* TotLns&Lses/Assets))
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(iii) The probability as a function of the predictors:

Answer to 10.1.a.iii:
p  (1  Exp[(14.7210  89.8336 * TotExp / Assets  8.3713 * TotLns & Lses / Assets)])1

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 Answer to 10.1.b:

Refer to the “Q1b” sheet in 10.1_Banks.xls

logit = 0.1835

Odds = 1.2014

p = 0.5458

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Probability = p = .0.5458 > 0.5= cut off.

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Therefore the predicted class for this new bank is 1, or “financially week”.

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Answer to 10.1.c:
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Cutoff value of p=0.5.

p 0.5
Odds   1
1  p 1  0.5
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If odds > 1 then classify financial status as “weak” (otherwise classify as “strong”).
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Logit = ln (odds) = ln (1) =0

If Logit > 0 then classify financial status as “weak” (otherwise, classify it as “strong”)
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Therefore, a cutoff of 0.5 on the probability of being weak is equivalent to a

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threshold of 1 on the odds of being weak, and to a threshold of 0 on the logit.

d) Interpret the estimated coefficient for the total loans & leases to assets ratio in terms of the
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odds of being financially weak.

Answer to 10.1.d:

A positive coefficient in the logit model translates into a coefficient larger than 1 in
the odds model.

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 In the logit model, the estimated coefficient for total expenses-to-assets ratio is
8.37. In the odds models, the coefficient is e8.37 w=4316. This means that an
increase of a unit in total loans & leases-to-assets is associated with an increase in
the odds of being financially weak by a factor of 4316.

Answer to 10.1.e:

Classification Confusion Matrix

Predicted Class

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1 0
Actual Class

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(Weak) (Strong)

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1
a b
(Weak)

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0
rs e(Strong)
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b
The classification error rate for truly weak banks, using a certain cutoff is
ab
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If this cutoff is lowered, then we classify more strong records as weak records (more
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zeros misclassified as 1).

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Now numerator of the classification error rate for truly weak is less than or equal to
b. Therefore the classification error rate for truly weak will be less than or equal to
the original (with the higher cutoff).

In order to minimize the expected cost of misclassification in this case, we need to

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decrease the cutoff.

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