Early Detection of Potential Bank Bankruptcy Through Financial Ratio Analysis: Multinomial Logistic Regression Model

Abstract

Prediction of potential bank bankruptcy based on financial ratios is a continuing research. This study is aimed to provide prediction model capable of explaining bank’s health, predicting or detecting early potential bankruptcy of bank, finding formula that can be applied to all banks, promoting sound banking and simultaneously creating economic prosperity of the country considering that bank is the country’s economic infrastructure. Statistical technique based on multinomial logistic regression model is used as method to test the model with categorical dependent variables given a set of independent variables. It is found that financial ratio related to bank’s capital adequacy is statistically significant (in two logit functions) in providing early detection of potential bank insolvency. The accuracy of predictions by the model is 75% for failed banks (BL), 62.50% for banks classified under special surveillance or banks in resolution (BDP), and 97.14% for healthy banks (BS). Financial ratios are believed to have contributed to the bankruptcy prediction model by 89.36%.