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Daniel Porath*

German savings banks and credit cooperatives

A bstract

Savings banks and cooperative banks are important players in the German financial mar-

ket. However, we know very little about their default risk, because these banks usually

resolve financial distress within their own organizations, which means that outsiders can-

not observe defaults. In this paper I use a new dataset that contains information about

financial distress and financial strength of all German savings banks and cooperative

banks. The Deutsche Bundesbank has gathered the data for microprudential supervision.

Thus, the data have never before been exploited for statistical risk assessment. I use the

data to identify the main drivers of savings banks’ and cooperative banks’ risk and to

detect structural differences between the two groups. To do so, I estimate a default pre-

diction model. I also analyze the impact of macroeconomic information for forecasting

banks’ defaults. Recent findings for the U.S. have cast some doubt on the usefulness of

macroeconomic information for banks’ risk assessment. Contrary to recent literature, I

find that macroeconomic information significantly improves default forecasts.

1 I ntroduction

We must treat bank defaults particularly seriously, since they are associated with a poten-

tial destabilization of the financial system through contagion. Therefore, a healthy banking

system is a pivotal point for financial stability.

When measuring the default risk of banks, analysts typically focus on big banks. Rating

agencies provide ratings for about 40 German banks, mostly private banks and Landes-

* Daniel Porath, Professor of Business Administration and Quantitative Methods, University of Applied Sciences,

Mainz, An der Bruchspitze 50, D-55122 Mainz, Tel: +49 (0) 6131 628 143, Fax: +49 (0) 6131 628 111, e-mail:

daniel.porath@wiwi.fh-mainz.de.

214 sbr 58 July 2006 214-233

Default Probability

banken. The Credit Monitor of Moody’s KMV includes only publicly listed banks, which

in Germany amount to 21 institutions. However, there is almost no empirical evidence for

the default risk of cooperative banks or savings banks. According to Deutsche Bundes-

bank (2004), these banking groups are important players in the German market, since

they represent roughly 25 % of the total assets of all German banks and grant about 35 %

of all loans to German non-banks. Furthermore, their ownership structure and busi-

ness focus differs considerably from the banks that rating agencies focus on. Obviously,

ignoring the default risk of these banking groups can cause a severe bias in assessing the

total risk of the banking sector.

From a microeconomic perspective, it is also desirable to learn more about the risk and the

risk drivers of savings and cooperative banks. For example, the modern risk control tech-

niques that are permitted under the Revised Capital Framework of the Basel Committee

on Banking Supervision (Basel II) require that creditors be able to estimate their debtors’

probabilities of default (PDs). For private customers and non-financial corporations there

are many well-established methods for the estimation of PDs and a sizeable body of

evidence about the main risk drivers. However, there is almost no comparable literature

for savings banks and cooperative banks. For savings banks, the problem was mitigated to

some extent by the fact that credits virtually were publicly guaranteed. However, by July

2005 these guarantees have phased out.

The fact that there is so little knowledge on the default risk of savings and coopera-

tive banks can be explained by a lack of data due to a German particularity: German

savings and cooperative banks usually resolve financial distress within their own organi-

zations. Therefore, there is no publicly available default data for these banking groups.

In this paper, I present some empirical evidence, thanks to the unpublished data set at

my disposal. The data set covers default data, balance sheet information, and supervisory

reports for all German banks from 1993 to 2002. The Deutsche Bundesbank has gath-

ered these data, and the data set has never before been exploited for model-based risk

assessment.

I use the data to estimate the individual PDs for savings banks and cooperative banks. I do

this by using a default prediction model that allows me to identify the main risk drivers.

I also use the model to analyze possible structural differences in the default risk between

savings banks and cooperative banks.

I also assess how much of the model outcome can be attributed to internal (bank-specific)

factors and how much to external factors (macroeconomic developments). This issue has

growing importance, since deregulation and increased competition seem to have tight-

ened the link between the riskiness of savings and cooperative banks and macroeconomic

developments. In fact, the recent economic downturn, with numerous insolvencies and

See Moody’s Investor’s Service (2003). There are only few exceptions: for example, Stadtsparkasse Köln, Deka

Bank, DZ Bank, and WGZ-Bank.

As mentioned above, there are some exceptions, like the Stadtsparkasse Köln which is rated by Moody’s. I exclude

the Landesbanken, the DZ Bank, and the WGZ-Bank when referring to savings banks and credit cooperatives.

See Schmidt and Tyrell (2004) for an overview of the German financial sector.

D. Porath

the collapse of the stock market, has probably had a greater impact on their resilience

than ever before in the post-war period (see, e.g., IMF (2003)). Contrary to this intu-

ition, Nuxoll (2003) finds that macroeconomic information does not improve the fore-

casts of bank defaults. However, his work is limited to U.S. banks. There is no empirical

work for Germany. Since I expect different results for Germany, I use my data set to

analyze the question. I approach the questions raised in this section with a panel binary

response model.

The paper is organized as follows. In Section 2 I briefly review the relevant literature.

Section 3 states the goals more precisely and describes the data. In section 4 I discuss the

methods used for estimation and in section 5 I provide an overview of the methods used

for the model specification. Section 6 presents the results and section 7 compares the

results of savings banks and cooperative banks. Section 8 concludes.

2 R elated studies

Starting with work of Altman (1968) and Beaver (1968), we can look back at more than

three decades of experience in using statistical models to predict defaults. Soon after their

introduction, studies applied these methods to banks, for example, Sinkey (1975) and

Martin (1977). At the beginning, discriminant analysis was the leading method. The

drawback to this method is the assumption of normally distributed regressors. As gener-

ally financial ratios are not normally distributed, since the 1980s maximum-likelihood

methods have been used more frequently (Martin (1977), see also the overview of the

literature in Lennox (1999)). Logit and probit procedures are advantageous not only for

statistical reasons but also because they directly estimate PDs.

Logit and probit models and discriminant analyses are all cross-sectional methods. Since

the data on bank defaults are typically gathered at different points in time – as is the case

here – more recent studies such as Cole and Gunther (1995), Shumway (2001) or Estrella

et al. (2000), favor the use of hazard models. Many authors use the Cox proportional

hazard model, which exploits the fact that the default data are available on a daily basis;

see, for example, Lane et al. (1986) or Molina (2002). Instead, I argue that bank defaults,

although available with daily frequency, can only be interpreted on an annual basis. The

following section shows that the supervisory (or internal) act which constitutes the default

typically is the result of the balance sheet audit. In most cases the exact timing of the audit

or of the default event itself is not driven by economic factors but merely by procedural

circumstances. Consequently, only the year of the default gives reasonable information

for modelling. Therefore the dataset for bank defaults typically has a panel structure. For

panel data, hazard models are equivalent to panel binary response models, see Shumway

(2001) or Hamerle et al. (2004) for examples.

I use panel binary response models because they offer the possibility to estimate bank-

specific and macroeconomic variables simultaneously. With the exception of Nuxoll

(2003), there is little evidence on the importance of macroeconomic information for

forecasting banks’ default. In his paper, Nuxoll explicitly investigates the contribution of

216 sbr 58 July 2006 214-233

Default Probability

macroeconomic and regional economic data to bank-failure models and finds that these

variables impair the forecasting power of the model.

A PD for a given bank captures the probability that the bank will default within a certain

period. If, as is customary, the period covers the following year, then the mean PD (aggre-

gated across all banks) is an estimator for the default rate of that year. But first of all I

clarify what exactly is meant by default.

Most one of us would define default as insolvency. The problem arises from the fact that

savings banks and cooperative banks do not become insolvent, because the deposit guar-

antee scheme for these banking groups guarantees the going-concern basis, for example

with capital preservation measures or by a merger with a healthy institution of the same

banking group and region. Therefore, I define default (i) as any intervention on part of

the supervisory authority, the auditor, or the deposit guarantee scheme (disclosure of facts

pursuant to section 29 (3) of the Banking Act (BA), moratoriums pursuant to section

46a of the BA, capital preservation measures, or also the application for such and restruc-

turing caused by mergers); or (ii) as high losses (losses amounting to 25 % of liable capital

or a negative operating result in excess of 25 % of liable capital). I develop this defini-

tion of default from a supervisory perspective. The purpose of prudential supervision is

to prevent insolvencies, so the definition covers all events indicating that the bank is in

danger of ceasing to exist as a going-concern without outside intervention. The Bundes-

bank’s database makes default information available for the years between 1995 and 2002.

During that time, a triple-digit number of credit cooperatives and savings banks under-

goes one of the default events. The exact total number of defaults is confidential Bundes-

bank information.

The data set for the explanatory variables combines financial information about indi-

vidual banks with macroeconomic data. Due to the regional restrictions of savings banks,

I also use regional macroeconomic data. I do not incorporate market information, since

the banking groups are not publicly traded and there is very little other market informa-

tion available. The Federal Statistical Office (Statistisches Bundesamt) and the Bundesbank

(monthly reports) gather the macroeconomic time series. As mentioned earlier, I obtain

the financial data from an unpublished Deutsche Bundesbank database that covers balance

sheets, profit and loss accounts, key figures from the audit report, information about the

credit portfolio (credit register), etc. Most of the data is gathered annually and is avail-

able for each year from 1993 on. The Bundesbank collects individual bank data for statis-

tical and supervisory purposes. Therefore, the data set covers not only all banks, but also

all the financial ratios that are generally used for the risk assessment of a bank. To the best

of my knowledge, I am the first to analyze the risk of German savings banks and cooper-

ative banks with one data set of similar quality.

A detailed overview of the data is given by the respective reporting forms that the banks are required to provide

and which are published by the Bundesbank (www.bundesbank.de).

D. Porath

To add the default information to my data set, I create a dummy variable Yt that takes the

value of one if a default is observed in the year t, and zero otherwise. I eliminate from the

sample banks that are still in existence after default.

Year Number ∆ Default rate* Number ∆ Default rate*

1995 2,450 638

1996 2,358 0.80 % 598 -3.09 %

1997 2,247 0.04 % 586 -0.33 %

1998 2,078 -0.43 % 581 0.52 %

1999 1,872 0.37 % 563 -0.86 %

2000 1,639 -0.36 % 548 1.09 %

2001 1,474 0.77 % 525 0.81 %

2002 1,338 -1.05 % 498 -0.10 %

Total 15,456 4,537

* ∆ Default rate is the difference between default rate in the current year and the previous year.

Table 1 reports the distribution of the total number of savings banks and cooperative

banks. Consolidation is an ongoing process within both banking groups, and the total

number of institutions is continuously diminishing. Virtually all exits from the markets

are intragroup mergers. Since the number of defaults is confidential, I report the first

differences of the default rate series. These figures show important fluctuations in risk

over time. Most notably, the increased difficulties of the banking sector in recent years are

reflected in a peak of the default rate in 2001.

The total number of savings banks’ defaults is too small to develop two separate models

for both banking groups. Savings banks and cooperative banks are similar in their

regional focus and organization. Therefore, I assume homogeneity and estimate an overall

model, then review the validity of the overall model for the subpopulations.

4 M ethod

As noted, my main rationale for using a panel model is that it allows me to combine

micro- and macroeconomic information. The panel binary response model is given by

5 At the time of the survey (2004) the number of defaults for 2003 was not complete. The total number of institu-

tions is not consistent with the official Bundesbank statistics since the latter still include some institutions which,

according to our default definition, have defaulted. A few institutions could not be included in the analysis since

they failed to submit returns.

218 sbr 58 July 2006 214-233

Default Probability

m n

∑

j = 1

∑

λit = Φ(Sit) with Sit = β 0 + β j Xit – 2, j + γ

j zt – 2,j + λ0t + λi0 , (1)

j = 1

where λit gives the PD of bank i at time t, and Sit is the score that constitutes an order

of the banks according to their riskiness. The link function Φ transforms the score into

the PD. Xit – 2 and zt – 2 are (m x 1) and (n x 1) vectors of covariates. Xit-2 comprises bank-

specific variables such as financial ratios, and zt − 2 captures macroeconomic factors that

are constant for all i. β and γ are (1 x m) and (1 x n) vectors of coefficients. λ0t is the

(unobserved) time effect and λi0 is the (unobserved) individual effect.

The rationale for the two-year lag is that most of the default events are the result of the

balance sheet audit. Consequently, a default occurring in the year t is caused by the finan-

cial situation in the year t – 1. Because of the forecast horizon of one year, I introduce

one further lag.

For the estimation, I replace λit by the dummy variable Yit, which I explained in the

previous section. Defaulted banks either cease to exist or are excluded from the sample.

Hence, Yit is restricted in the following way: for defaulted banks, Yit is a sequence in

which the first values are all zeroes and the last value is one, otherwise (non-default) Yit

is always zero. When it includes such a restriction, the binary panel model is also called a

“time-discrete hazard model.”

The choice of the link function is usually arbitrary, since there are no economic indica-

tions on which function to use. However, in many empirical studies the outcome does

not seem to depend much on the specific link function. In what follows, I alternatively

estimate my model with the logit,

e

Φ(Sit) = _____

Sit

, (2)

1 + e

Sit

the probit

Sit

∫

x2

__

–

1

Φ(Sit) = ____

___ e 2 dx, (3)

√ 2π

–∞

Equations (2), (3), and (4) are the most widely used link functions for empirical analysis,

(2) because of its computational simplicity, (3) because of the popularity of the normal

distribution, and (4) because it is the discrete-time version of the proportional Cox model

(see Kalbfleisch and Prentice (1980)). Both (2) and (3) are symmetric and give similar

values, although the tails of the logistic distribution are heavier than that of the normal

distribution. Equation (4) is asymmetric.

D. Porath

For the time effect λ0t I assume the fixed-effects model. I do not consider random-effects

models because they are computationally more extensive and require the assumption

that different λ0t are not temporally correlated. The fixed time-effects can be captured

by including year-dummies in the estimation. Forecasting with a model that contains

year dummies results in a two-step procedure in which the first step, forecast values for

the dummy, must be fixed. Instead, I prefer a one-step estimation in which I minimize

the time effect by choosing appropriate variables. Thus, minimizing the time effect is

part of my specification strategy. Therefore, I begin by estimating a model without λ0t.

There are no fixed-effects models for the individual effect λi0. The only exception is

the approach proposed by Chamberlain (1980) for the logit link function. However,

his method requires that the individuals manifest a change of the status in the endoge-

nous variable and omits all other individuals from the sample. Such a procedure is not

feasible for default data, as it would restrict the sample to the defaulted banks. There-

fore, I model λi0 as a random effect.

There are two kinds of panel binary response models. One type is cluster-specific models,

which calculate coefficients that must be interpreted in a manner specific to the institu-

tion. A cluster-specific coefficient βi represents the average of the individual institution’s

reaction (measured in logit changes for the logit model) to a change in a covariate. By

contrast, population-averaged models measure the logit change of an average institution

in reaction to a change in the covariate Xi. Both averages are different because Equations

(2), (3), and (4) are nonlinear models. Besides, both methods produce different estimates

for the endogenous variable. The cluster-specific model estimates PDs that are conditioned

on the individual effect. Estimation does not produce values for the individual effect, but

only determines its variance. Thus, the output for a specific bank is similar to an interval

estimation of the PD. In the population-specific model case, the output PD can be inter-

preted as an average value for all individuals with the same covariate structure. Gener-

ally, for forecasting purposes both models are meaningful, so I estimate them both. Since

I find only negligible differences in the estimated coefficients and PDs, in the following I

present only the results of the population-averaged model.

I follow Zeger and Liang (1986) by estimating the population-averaged model with the

Generalised Estimating Equations (GEE). The GEE method incorporates correlation

between the observations into the estimation process. The estimation equations, i.e., the

equations to solve for the coefficients βj, are derived from the link function and a so-

called working correlation matrix. The working correlation matrix reflects the correla-

tion structure between the observations that belong to the same individual. In contrast

to maximum likelihood techniques, there is no need to impose a distributional assump-

tion. The key feature of GEE is that the estimators are asymptotically consistent even if

the working correlation matrix is not correctly specified. For my estimation I choose the

standard exchangeable working correlation, which means that I assume that all observa-

tions of one bank have the same correlation.

More details on this method can be found in Hosmer and Lemeshow (2000).

220 sbr 58 July 2006 214-233

Default Probability

5 M odel specification

Economic theory gives only a rough guideline for specifying a rating model. The usual

procedure is to define categories of variables that are supposed to impact on the future

capitalization. Examples are the categories of capital adequacy, asset quality, manage-

ment quality, earnings, liquidity, and sensitivity to market risk, called (CAMELS), and

Moody’s RiskCalc Model for held U.S. banks, with the categories capital, asset quality,

concentration, liquidity, profitability, and growth, see Kocagil et al. (2002). German bank

supervisors customarily use the categories capital, profitability, liquidity, credit risk, and

market risk, which I use for my analysis. I also include the business cycle and macroeco-

nomic prices in my analysis. For each category I calculate variables from the information

contained in my database. I have to omit the liquidity category from further analysis, since

I cannot measure it adequately with my data. Table 2 presents the categories with some

examples of variables.

Bank-specific variables

Capital Equity capital to total assets

Profitability Cost income ratio, EBIT to equity capital, operating

results to equity capital

Credit risk Nonperforming loans to total loans, loan loss provi-

sions to total loans, customer loans to total assets, large

credits to total credits

Market risk Volume of stocks to total assets, net results from trans-

actions with foreign currencies to total assets, net

results from transactions with derivatives to operative

results

Macroeconomic variables

Business cycle indicators GDP, money supply, unemployment, Ifo index “business

situation”, Ifo index “business expectations”

Macroeconomic prices Interest rates, stock prices, goods prices, oil price

Following the practice of rating agencies (see, e.g., Falkenstein et al. (2000) or Kocagil et

al. (2002)), I calculate many variables for the empirical analysis (roughly 100 variables,

see table 2 for some examples). I choose the most adequate variables based on univariate

CAMELS is the bank rating system used by U.S. federal depository regulators, mainly for on-site examination.

Unlike Kocagil et al. (2002), there is no separate category for growth since typically growth ratios are observed for

each category. Additionally, concentration and asset quality are subsumed into credit risk and there is a separate

category for market risk (which covers interest rate risk, equity price risk, commodity price risk, and exchange

rate risk).

D. Porath

and multivariate analysis. The final model should contain at least one variable from each

category.

In the univariate analysis, I analyze each variable separately before creating the model.

There are two main reasons for this preliminary univariate procedure. First, as table 2

shows, there are often alternative ways of measuring the same risk factor. For example,

profitability can be measured by net income or EBIT and, without looking at the data,

it is controversial which ratio performs best. The second and more important reason is

to find out which variables have to be transformed prior to modeling. Variable transfor-

mation improves the forecasting performance when the relation between the variable and

the PD is not monotonic. Equation (1) shows that for each bank, the PD is a monotone

function of the covariates. For many variables monotony is a reasonable assumption and

there is no need for a transformation. For example, I expect that a rising equity ratio will,

ceteris paribus, lead to a lower PD on the average of all banks. However, there are some

exceptions, the most important being variables that are affected by volatility. Generally,

high volatilities indicate increased riskiness. Due to a lack of long time series, rating

systems often incorporate annual changes of ratios instead of volatility, with the result that

the risk patterns are non-monotonic. The growth of the equity ratio, for example, typi-

cally manifests a (negative) monotone relationship to PD for low and moderate values.

However, due to volatility, very high values may be associated with growing PDs. If this

is the case, then the predictive power of the variable in the model can be enhanced when

the variable is transformed for all banks, so that the resulting variable is a monotone func-

tion of PD.

I measure the predictive power of a variable and analyze the monotonic assumption with

the help of two statistical tools, the area under the receiver operating characteristic curve

(AUR) and the information value (IV ). I can calculate AUR by first ordering the data

according to the variable of interest and then calculating the percentages of defaults and

non-defaults above a certain threshold value of the variable. The receiver operating char-

acteristic (ROC ) curve plots the percentages of the defaults against the percentages of

the non-defaults for all possible threshold values. As an example, figure 1 shows the ROC

curve for the ratio of operating results to equity. The distance of the curve from the diag-

onal is a graphical measure of the discriminative power of the variable. AUR is given by

the area under the ROC curve. As the coordinates are normalized to unity, the values of

AUR range between one (maximal positive discriminative power) and zero (maximal

negative discriminative power). If AUR equals 0.5, the variable has no discriminative

power. For more details on AUR and the ROC curve, see Hosmer and Lemeshow (2000)

or Engelmann et al. (2003).

The predictive power of a variable can be measured with a variety of other methods such as the accuracy ratio or

the Mann-Whitney U-test, most of which are equivalent to AUR (see Engelmann et al. (2003)), but not to IV.

222 sbr 58 July 2006 214-233

Default Probability

EFGBVMUT

OPOEFGBVMUT

"SFBVOEFS30$DVSWF

The AUR presumes that the monotonic assumption is valid. A measure that is appro-

priate without the monotony assumption is the information value (IV ). For calculating

IV, I group the sorted data into i classes. Then IV is

K

∑

IV = (pNi – pAi) ln __

i=1

( )

ppNi ,

Ai

where pAi is the percentage of defaults in class i, pNi is the percentage of non-defaults in

class I, and K is the total number of classes. IV measures, in terms of log-odds, how the

a priori forecast (default rate of the portfolio) can be improved with the help of the vari-

able. IV ranges from zero to infinity. Higher values are associated with a higher discrim-

inative power of the variable.

For each variable, I calculate IV and AUR and draw the ROC curve. If high IV is associ-

ated with low AUR and the ROC is not convex (or concave), an adequate transformation

may have a great impact on the performance. In my transformation I replace the variable

with its likelihood ratio lr = pA/pN , where pA and pN are the estimated density functions

of the variable for the defaulters (pA) and for the non-defaulters (pN). I can estimate the

density functions from the sample with kernel estimation10. This transformation is optimal

in the sense that it maximizes the AUR.

Building on the results of the univariate analysis, I start with the model specification. The

model building process is guided by the following ideas. First, the model should contain

10 For my calculations I use the Gaussian kernel in which the width of the density window is determined by the

rule of Silverman (1986).

D. Porath

all categories of variables, as shown in table 2. Second, I should choose only variables with

a significant (univariate and multivariate) impact on the historical defaults. Third, the

model should have a high discriminative power (as measured by AUR); and fourth, the

annual average PDs should fit the historical default rates. During the specification, I test

for the stability of the model by randomly defining hold-out samples and by analyzing the

single years separately. The model I finally choose is re-estimated with the whole sample.

The stability analysis results can be found in Porath (2004).

6 R esults

Table 3 presents the coefficients of the population average model for alternative link func-

tions. Table A1 of the appendix provides the details about variables and data sources. All

coefficients have the expected sign and are significantly different from zero.

Tier 1 capital to risk-weighted assets in t-2 -0.109 -0.066 -0.149

(-2.365) (-1.973) (-2.331)

Undisclosed reserves to balance sheet total in t-2 -1.307 -0.879 -1.852

(-7.647) (-7.278) (-7.793)

Undisclosed losses to Tier 1 capital in t-2 0.024 0.022 0.033

(1.866) (2.085) (1.845)

Operating results to Tier 1 capital in t-2 -0.006 -0.007 -0.006

(-2.527) (-3.359) (-2.024)

Customer loans to balance sheet total in t-2 0.034 0.022 0.049

(4.040) (3.567) (4.285)

Customer loans in t-2 to customer loans in t-3 (transf.) 0.278 0.255 0.382

(2.167) (2.469) (2.210)

Loans with increased risks to audited loans in t-2 0.018 0.015 0.024

(4.215) (4.547) (4.047)

[Fixed-rate liabilities – fixed-rate assets] to balance 0.039 0.030 0.052

sheet total in t-2 (7.114) (6.995) (7.129)

Capital market interest rate, annual change 0.287 0.252 0.358

(yield outstanding) in t-2 (3.278) (3.756) (2.999)

Firm insolvencies to total number of firms 0.866 0.631 1.218

(state level) in t-2 (4.203) (3.801) (4.386)

Constant -5.016 - 4.524 -7.295

(-5.885) (-7.032) (-6.259)

AUR 0.809 0.814 0.807

R² 0.592 0.467 0.710

The appendix contains descriptions of the variables and data sources. All ratios in per cent, z-values (Wald-test) in brackets. For reasons of

comparability, I multiply the coefficients of the probit (complementary log-logistic) model by π/31/2(21/2). R² refers to a regression of the

annual average PDs on the historical default rates.

11 With the help of the method proposed by Pregibon (1981), outliers were identified and eliminated from the

analysis prior to estimation. In our data set, this study ended up excluding three (solvent) banks.

224 sbr 58 July 2006 214-233

Default Probability

I measure the current capitalization with the three ratios that comprise tier 1 capital:

the ratios of undisclosed reserves and undisclosed losses due to a transfer of securities,

and the ratio of stocks or bonds to fixed assets. I model the current returns with oper-

ating results, credit risk with customer loans (level and growth), and loans with increased

risks. The growth of customer loans enters the model after I transform it with the contin-

uous approach described in the previous section. I measure market risk by the difference

between fixed-rate liabilities and fixed-rate assets. Finally, the model includes the growth

of the capital market interest rate and regional insolvencies as macroeconomic factors.

As noted earlier, I estimate the models given in table 3 without time effects, so when I

evaluate the performance, I consider both the discriminative power and the fit with the

historical default rates. The AUR of roughly 81% shows that all three models have a high

discriminative power. As measured by R², the cloglog model seems to explain the annual

default rates better than the other models. However, this result is not reliable, since the

calculation of R² is based on the time series dimension; hence the sample is restricted to

seven observations.

To find out whether the three models perform differently in terms of fit, I compare the

empirical default distributions with the theoretical density functions (for the calibra-

tion I use the empirical mode and variance). The plot (see figures A1, A2 and A3 in the

appendix,) shows a similar fit for all link functions, so the choice of the specific function

is arbitrary. For convenience, I discuss only the results from the logit link function. The

conclusions I reach from the following discussion are unaffected by the choice of the link

function12.

Figure 2 illustrates the fit of the estimated average PDs to the historical default rates. Since

the default rates are confidential Bundesbank information, I plot the deviations from the

mean. The model is a good predictor for the direction of the development: with only one

exception (in 1998), the model predicts the upward and downward movements of the

default rate. However, the R² presented in table 3 are quite low, indicating that the model

fits the levels of the default rates only poorly. Figure 2 shows that this is particularly true

for the years 1996 to 1999. In the following years, the model better predicts the levels of

the default rates. Most notably, the model explains the peak of the year 2001 and also the

sharp decline in 2002. I assume that the different performance in both subperiods is due

to a structural change in the default time series, which probably reflects the severe prob-

lems of the German banking system in the last few years (and the efforts to overcome

them). This explanation is confirmed by the finding that in the model building process,

I am able to estimate models with different variables and a similar overall performance.

These models all show a good fit with the first subperiod, but they are not able to explain

the peak in the year 2001. Finally, I opt for a model with the variables given in table 3,

because I attribute greater importance to the more recent development.

D. Porath

Figure 2: Average PDs and historical default rates (deviations from the

average values)

QFSDFOU

ZFBS

EFGBVMUSBUF EFWGSPNNFBO

1% EFWGSPNNFBO

An unbiased estimation of the standard errors in table 3 requires that the time effects λ0t

be zero. To test this hypothesis, I introduce dummy variables separately13 for the indi-

vidual years. The results of the Wald tests reported in table 4 show that there are no

significant time effects in any of the years14.

Dummy 1996 0.664 0.392 0.196

(1.656) (2.243) (0.639)

Dummy 1997 0.330 0.140 0.319

(1.529) (1.547) (1.506)

Dummy 1998 -0.058 -0.034 -0.043

(-0.299) (-0.420) (-0.224)

Dummy 1999 -0.176 -0.072 -0.169

(-0.893) (-0.895) (-0.874)

Dummy 2000 -0.072 -0.03 -0.065

(-0.338) (-0.342) (-0.312)

Dummy 2001 0.062 -0.041 0.202

(0.162) (-0.250) (0.577)

Dummy 2002 -0.186 -0.08 -0.161

(-0.818) (-0.856) (-0.724)

Coefficients of the year dummy variables, z-values (Wald-test) in brackets.

13 The dummies cannot be introduced simultaneously due to the presence of the interest-rate change.

14 I do not take the significant probit coefficient of the 1996 dummy as evidence for the presence of a time effect,

since in the other models the coefficient is nonsignificant.

226 sbr 58 July 2006 214-233

Default Probability

model into two separate models, a model that contains only macroeconomic variables,

and another model that contains only individual variables. Table 5 shows the AUR and

the R² from a regression of the average default probability on the historical default rate

for the separate models.

I attribute the discriminative power (AUR) almost entirely to the individual bank data.

As in Nuxoll (2003), I find a poor discriminative power of the macroeconomic variables.

This result is not surprising, since these variables have a smaller variation: their values are

equal for each bank of the same year and region. More interestingly, I can attribute the fit

to the average default rate almost entirely to the macroeconomic factors. Obviously, bank-

specific data mainly determine the relative risk, i.e., the order of banks by riskiness, and

macroeconomic information mainly determines the level of risk. Eventually, risk models

that rely on financial ratios alone cannot predict the level of the PD. The results depend

on the choice of the macroeconomic variables – in my case, interest rates and regional

insolvencies. To generalize, macroeconomic variables enhance the forecasting accuracy if

the predictive information has not been (completely) transmitted to the balance sheet data

when the variables are observed. My findings show that this is the case for interest rates

and regional insolvencies. So, unlike Nuxoll (2003), I conclude that macroeconomic vari-

ables may play an important role in predicting defaults.

Next, I analyze the importance of the individual bank factors. This analysis is done in

terms of AUR, as the bank-specific variables mainly determine the discriminative power

of the model. I calculate the marginal contribution of a single variable to the discrimina-

tive power of the model by comparing the overall AUR with the AUR that results from a

model that excludes the variable. Table 6 reports the relative marginal contributions of all

bank-specific variables. The variables that are directly linked to the capitalization (equity,

and undisclosed reserves and undisclosed losses taken together) have the greatest infor-

mative importance. Among these factors, the undisclosed reserves have by far the most

predictive power. Obviously, banks that are in severe trouble will start to reduce their

undisclosed reserves. Market risk alone has a similar level of discriminative power as the

other risk factors taken together (credit risk and operating results).

D. Porath

Marg.

AUR

Tier 1 capital to risk-weighted assets in t-2 0.73%

Variables and data sources are described in the appendix, table A1.

I use my model to detect differences between the risk drivers of savings banks and cooper-

ative banks. Table 7 presents the univariate and multivariate AUR for both subsegments

and the results from the test of the hypothesis that both values are equal. Interestingly, for

most of the variables there are no significant differences between the subsegments. The vari-

ables for tier 1 capital and undisclosed losses show better performance for savings banks,

with a difference that is significant on a 5% level. The overall test results in a p-value of

6%, indicating that good and bad savings banks can be discriminated slightly better. This

result is astonishing, since in the estimation the number of cooperative banks (defaults and

nondefaults) is much larger than the number of savings banks. Although cooperative banks

dominate the estimation, savings banks perform slightly better. I interpret this finding as

evidence that the same risk drivers affect both banking groups. However, savings banks

reveal a higher risk sensitivity.

228 sbr 58 July 2006 214-233

Default Probability

savings Coop. AUR (savings banks)

banks banks = AUR (coop. banks)

Customer loans in t-2 to customer loans in t-3 (transf.) 0.5399 0.5747 0.4976

Loans with increased risks to audited loans in t-2 0.6108 0.6533 0.3477

sheet total in t-2

Capital markets interest rate, annual change 0.5179 0.5638 0.4177

(yield outstanding) in t-2

Firm insolvencies to total number of firms 0.5041 0.4445 0.3132

(state level) in t-2

Variables and data sources are described in the appendix, table A1.

The p-value of a joint Wald test of the hypothesis of equal coefficients amounts to 5.78%.

Here, the operating results and the market risk variable have a significantly lower coeffi-

cient in the savings banks’ equation (on the 5% level). Thus, the test confirms the result

of a higher risk sensitivity of savings banks, but attributes it to different variables.

8 C onclusion

German savings banks and cooperative banks constitute an integral part of the German

banking system. However, there is little evidence regarding their default risk. To fill this

gap, I propose a statistical model that estimates the PDs of both banking groups. My data

set combines default events with balance sheet information, audit reports, and macroeco-

nomic variables. I estimate a panel binary response model.

D. Porath

I find that the relevant factors for the estimation of a bank’s PD comprise the general

macroeconomic environment and the bank’s return, credit risk, market risk, and, most

important for determining the default risk, the capitalization. I also find that savings

banks and cooperative banks are affected by the same risk drivers, but savings banks are

more risk-sensitive.

default. My results show that rating tools that rely solely on financial ratios may not be

suitable for capturing the risk level of a bank. At the same time, adding macroeconomic

information to the model greatly improves the forecasting performance.

9 A ppendix

Tier 1 capital Tier 1 capital Deutsche Bundesbank,

Audit reports, unpublished

Risk-weighted assets Risk-weighted assets Deutsche Bundesbank,

Audit reports, unpublished

Undisclosed reserves Undisclosed reserves pursuant to sections 340f Deutsche Bundesbank,

and 340g of the German Commercial Code (HGB) Audit reports, unpublished

Balance sheet total Balance sheet total Deutsche Bundesbank,

Balance sheet, unpublished

Undisclosed losses Undisclosed losses due to a transfer of securities, Deutsche Bundesbank,

stocks or bonds to fixed assets Audit reports, unpublished

Operating results Operating results Deutsche Bundesbank,

Balance sheet, unpublished

Customer loans Volume of customer loans Deutsche Bundesbank,

Audit reports, unpublished

Loans with Loans with increased latent risks and provisioned Deutsche Bundesbank,

increased risks Loans according to the auditor’s classification Audit reports, unpublished

Audited loans Audited loans Deutsche Bundesbank,

Audit reports, unpublished

Fixed-rate liabilities Fixed-rate liabilities Deutsche Bundesbank,

Audit reports, unpublished

Fixed-rate assets Fixed-rate liabilities Deutsche Bundesbank,

Audit reports, unpublished

Capital market interest Yield on debt securities outstanding issued by Deutsche Bundesbank,

rate (yield outstanding) residents Monthly Reports

Firm insolvencies Annual number of firm insolvencies in a state Federal Statistical Office,

(state level) Germany

Total number of firms Number of value added tax payers in a state Federal Statistical Office,

(state level) Germany

230 sbr 58 July 2006 214-233

Default Probability

-JOFBSQSFEJDUJPO

-PHJTUJDEJTUSJCVUJPO
QBNPEFM &NQJSJDBMEJTUSJCVUJPO

-4 -3 -2 -1 0

Linear prediction

Normal distribution, pa model Empirical distribution

D. Porath

-JOFBSQSFEJDUJPO

-PH-PHJTUJDEJTUSJCVUJPO
QBNPEFM &NQJSJDBMEJTUSJCVUJPO

R eferences

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The Journal of Finance 23, 589-609.

Beaver, William H. (1968), Alternative accounting measures as predictors of failure, The Accounting Review 43,

113-122.

Chamberlain, Gary (1980), Analysis of covariance with qualitative data, Review of Economic Studies 47, 225-238.

Cole, Rebel A. and Jeffery W. Gunther (1995), Separating the likelihood and timing of bank failure, Journal of

Banking & Finance 19, 1073-1089.

Deutsche Bundesbank (2004), Banking statistics, Statistical supplement to the Monthly Report 1, June .

Engelmann, Bernd, Evelyn Hayden, and Dirk Tasche (2003), Testing rating accuracy, Risk 16, 82-86.

Estrella, Arturo, Sangkyun Park, and Stavros Peristiani (2000), Capital ratios as predictors of bank failure, Federal

Reserve Bank of New York: Economic Policy Review, July, 33-52.

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Hamerle, Alfred, Thilo Liebig, and Harald Scheule (2004), Forecasting credit portfolio risk, Deutsche Bundesbank

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Hosmer, David W. and Stanley Lemeshow (2000), Applied logistic regression, 2nd ed., New York et al.: Wiley.

IMF (2003), Germany: Financial System Stability Assessment, www.imf.org.

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Kalbfleisch, John D. and Ross L. Prentice (1980), The statistical analysis of failure time data, New York et al.: Wiley.

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Porath, Daniel (2004), Estimating probabilities of default for German savings banks and credit cooperatives,

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