Testing the Assumptions of Credit-scoring Models
Working paper no 28, 2005
In the paper a non-standard comparison of two hazard models with differently specified hazard functions is made: one with a logit specification and the other with a probit specification. The estimations assume that if two firms have identical values of the covariates, they also have identical hazard functions, that is, unobserved heterogeneity is assumed away. The presence of unobserved heterogeneity can cause several problems, therefore, as a specification check, the hazard functions are extended to also include unobserved heterogeneity. In addition to investigating the various specifications of the hazard function, the paper discusses the treatment in the literature of different types of exits. The conclusions in the article are the following: Firstly, there does not seem to be any major difference between the logit and the probit specification. Secondly, unobserved heterogeneity seems to be unimportant, probably because a number of proxies are used for inherently unobservable variables. Thirdly, the results differ depending on the event, which is modelled (financial distress versus pooled exits). This is the case for the estimated parameters as well as the predictive abilities of the models, no matter whether the specification for the hazard functions is the logit or the probit specification. The practical implication of the paper is that it is important to think careful about the specification of credit-scoring models.