Predicting default risk under asymmetric binary link functions

Abstract

In this article we propose the use of an asymmetric binary link function to extend the proportional hazard model for predicting loan default. The rationale behind this approach is that the symmetry assumption that has been widely used in the literature could be considered as quite restrictive, especially during periods of financial distress. In our approach we allow for a flexible level of asymmetry in the probability of default by the use of the skewed logit distribution. This enable us to estimate the actual level of asymmetry that is associated with the data at hand. We implement our approach to both simulated data and a rich micro dataset of consumer loan accounts. Our results provide clear evidence that ignoring the actual level of asymmetry leads to seriously biased estimates of the slope coefficients, inaccurate marginal effects of the covariates of the model, and overestimation of the probability of default. Regarding the predictive power of the covariates of the model, we have found that loan-specific covariates contain considerably more information about the loan default than macroeconomic covariates, which are often used in practice to carry out macroprudential stress testing.