A New Methodology for Estimating Internal Credit Risk and Bankruptcy Prediction under Basel II Regime

Credit risk estimation and bankruptcy prediction methods have utilized Altman’s Z-score method for the last several years. It is reported in many studies that Z-score is sensitive to changes in accounting figures. Researchers have proposed different variations to conventional Z-score that can improve the prediction accuracy. In this paper, we develop a new multivariate nonlinear model for computing the Z-score. In addition, we develop a new credit risk index by fitting a Pearson type 3 distribution to the transformed financial ratios. The results of our study have shown that the new Z-score can predict the bankruptcy with an accuracy of 98.6 % as compared to 93.5 % by Altman’s Z-score. Also, the discriminate analysis revealed that the new transformed financial ratios could predict the bankruptcy probability with an accuracy of 93.0 % as compared to 87.4 % using the weights of Altman’s Z-score.