JOURNAL OF MULTI-CRITERIA DECISION ANALYSIS

J. Multi-Crit. Decis. Anal. 14: 103111 (2006)

Published online in Wiley InterScience
(www.interscience.wiley.com) DOI: 10.1002/mcda.405
AMulticriteria Decision Framework for Measuring Banks
Soundness Around theWorld
CHRYSOVALANTISGAGANIS
a
, FOTIOSPASIOURAS
b,
* and CONSTANTINZOPOUNIDIS
a
a
Financial Engineering Laboratory, Department of Production Engineering and Management,Technical
University of Crete, University Campus, Chania 73100, Greece
b
School of Management, University of Bath, Claverton Down, Bath BA27AY, UK
ABSTRACT
In this paper, we use a sample of 894 banks from 79 countries to develop a multicriteria decision aid model, for the
classication of banks into three groups on the basis of their soundness. The model is developed with the UTilite s
Additives DIScriminantes (UTADIS) method, through a 10-fold cross-validation procedure using six nancial and
four non-nancial variables. The ratings of Fitch form the basis for assigning banks into the three groups. The
results indicate that the asset quality (as measured by loan loss provisions), capitalization, and the market where
banks operate are the most important criteria (in terms of weights) in classifying the banks. Protability and
eciency in expenses management are also important attributes, whereas size and listing in a stock exchange are the
least important ones. UTADIS achieves higher classication accuracies than discriminant analysis and ordinary
logistic regression which are used for benchmarking purposes. Copyright # 2007 John Wiley & Sons, Ltd.
KEY WORDS: multicriteria classication of banks soundness; UTADIS
1. INTRODUCTION
Over the last years, various studies have attempted
to develop models for assessing bank soundness
either by predicting bank failure or by examining
the credit ratings of banks. Studies falling within
the rst category have used various methodologies
such as discriminant analysis (DA) (Sinkey, 1975;
Canbas et al., 2005), logit analysis (e.g. Rose and
Kolari, 1985; Pantalone and Platt, 1987; Canbas
et al., 2005), probit analysis (Cole and Gunther,
1998; Canbas et al., 2005), multidimensional
scaling approach (Mar-Molinero and Serrano-
Cinca, 2001), neural networks (Tam and Kiang,
1992), trait recognition (Kolari et al., 2002; Lanine
and Vander Vennet, 2006), multicriteria decision
aid (Kosmidou and Zopounidis, 2007) and neural
fuzzy systems (Tung et al., 2004). Many of these
studies have been successful in predicting bank-
ruptcy. However, one common drawback is that
they had concentrated on the classication of
banks into two groups, failed and non-failed.
Obviously, the classication of banks as bad or
good reduces the usefulness of the model.
With respect to the second category, although
several studies have examined the ratings assigned
to bonds (Horrigan, 1966; Pinches and Mingo,
1973; Kaplan and Urwitz, 1979; Belkaoui, 1983;
Ederington et al., 1987; Kim, 1993; Huang et al.,
2004) or countries (e.g. Hammer et al., 2006; Yim
and Mitchell, 2005) there have been only a few
studies that examine the individual ratings as-
signed to banks such as the ones of Poon et al.
(1999), Poon and Firth (2005), Pasiouras et al.
(2006, 2007) and Demirguc-Kunt et al. (2006).
However, with the exception of Pasiouras et al.
(2007) who developed a classication model for
the rating of Asian banks, these studies are of a
more explanatory nature focusing on the determi-
nants of ratings rather than on the correct
classication of banks. More precisely, Poon
et al. (1999) examined the determinants of
Moodys ratings, using logistic regression, while
Poon and Firth (2005) focused on the dierences
between solicited and unsolicited ratings. Pa-
siouras et al. (2006) focused on the impact of
bank regulations and supervisory framework on
the ratings, while Demirguc-Kunt et al. (2006)
focused on the relation between compliance with
Basel core principles and bank soundness.
*Correspondence to: School of Management, University
of Bath, Claverton Down, Bath BA2 7AY, UK.
E-mail: f.pasiouras@bath.ac.uk
Copyright # 2007 John Wiley & Sons, Ltd.
While the development of a bankruptcy prediction
model or a model to replicate all the ratings of a
credit agency is beyond the scope of the present
paper, our work is nevertheless related to these two
strands of the literature. The objective of the present
study is the development of quantitative models for
the classication of banks into dierent groups on
the basis of their soundness. While our model is
based on the ratings of Fitch, to assess the soundness
of banks,
1
we do not attempt to replicate all the
ratings of Fitch, as the heterogeneous sample used in
our study, consisting of 894 banks from 79 countries,
could result in poor classications.
2
We, therefore,
classify banks into three general groups. The rst
group contains very strong or strong banks; the
second one contains adequate banks, while the third
group contains banks with weaknesses or serious
problems. While we acknowledge that this approach
might reduce the information provided by the
model, we believe that it does not reduce the
applicability of the model and the importance of
our study. For example, several studies have high-
lighted the importance of developing early warning
systems to identify troubled banks (e.g. Kolari et al.,
2002; Tung et al., 2004; Canbas et al., 2005; Lanine
and Vander Vennet, 2006). By focusing on non-
failed banks, and distinguishing between healthy,
adequate and troubled banks, our model can reduce
the expected cost of bank failure, either by minimiz-
ing the costs to the public or by taking actions to
prevent failure (Thomson, 1991). For example, Ravi
Kumar and Ravi (2007) mention, As a bank or rm
becomes more and more insolvent, it gradually
enters a danger zone. Then, changes to its operations
and capital structure must be made in order to keep
it solvent (p. 1). Hence, the model developed in the
present study could be used in future applications to
provide an assessment of the soundness of banks not
rated by Fitch or other agencies (e.g. Moodys) as
well as to monitor changes in the status of banks
from one year to another.
The model is developed with UTilite s Additives
DIScriminantes (UTADIS) multicriteria technique
following a 10-fold cross-validation procedure.
UTADIS is well suited for examining the sound-
ness of banks for several reasons. First, the groups
in our study are dened in an ordinal way, in
the sense that banks classied into the rst group
are preferred to banks classied into the second
group, and so on. Traditional statistical classica-
tion methods as well as popular machine learning
techniques (e.g. neural networks, rule induction
algorithms and decision trees) cannot cope with
this kind of information. On the other hand,
UTADIS is well suited to the study of ordinal
classication problems. Second, UTADIS is not
based on statistical assumptions that often cause
problems to the application of statistical methods,
3
such as the normality of the variables or the group
dispersion matrices (e.g. DA) and is not sensitive
to multicollinearity or outliers (e.g. logit analysis).
Third, it can easily incorporate qualitative data.
The rest of the paper is as follows: Section 2
presents the sample and the variables used in the
study, while Section 3 outlines the UTADIS
technique. Section 4 discusses the empirical results,
and Section 5 concludes the study.
2. SAMPLE AND VARIABLES
2.1. Sample
The data set consists of those banks that had
available nancial and non-nancial data and
1
Demirguc-Kunt et al. (2006) also used ratings to
measure bank soundness. However, they used the
ratings of Moodys and focused on the relation between
compliance with Basel core principles and bank sound-
ness and did not develop a classication model.
2
One could argue that we could limit the heterogeneity
in the sample by decreasing the number of countries and
increasing the number of banks in the sample. However,
this is not possible since we have considered all the
banks rated by Fitch, with available data in Bankscope,
and by denition, we can only consider rated banks.
Hence, decreasing the number of countries is not an
alternative as this approach would limit the number of
banks in the sample resulting in an inecient estimation
of the model.
3
Barniv and McDonald (1999) summarized some of the
problems related to discriminant, logit and probit that
were mentioned in previous studies. Logit and Probit are
sensitive to: (a) data properties, such as departure from
normality of nancial variables (Frecka and Hopwood,
1983; Richardson and Davidson, 1984; Hopwood et al.,
1988); (b) overall small sample size (Noreen, 1988; Stone
and Rasp, 1991); (c) multicollinearity (Aldrich and
Nelson, 1984; Stone and Rasp, 1991). The basic
assumptions of discriminant analysis (DA) such as
normality, symmetry and equal covariance matrices
are also usually violated. Hopwood et al. (1988) pointed
out that DA is generally sensitive to departure from
normality and both logit and probit analyses are
sensitive to extreme non-normality.
C. GAGANIS ET AL. 104
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda
Fitch individual bank ratings in Bankscope
database.
4
The ratings correspond to October
2004, while the bank-specic characteristics corre-
spond to end of 2003 or March of 2004 depending
on the date of publication of the annual report.
The above selection criteria yielded a sample of
894 banks operating in 79 countries.
Table I presents the denitions of Fitch indivi-
dual bank ratings along with the coding used in the
present study. The ratings are based on AE scale
and represent Fitchs view on the likelihood that the
bank would fail, and therefore require support to
prevent it from defaulting. Fitch may also assign
the following intermediate ratings: A/B, B/C, C/D
and D/E. As mentioned earlier, the purpose of the
present study is not to explain or replicate the
ratings of Fitch, but rather to use them as the basis
for the development of a general model to assess the
soundness of banks. We, therefore, classify the
banks into three broad groups. The rst consists of
banks with ratings A and B (i.e. very strong or
strong banks), the second with banks rated C (i.e.
adequate banks), and the third with banks rated D
and E (i.e. banks with weaknesses or serious
problems). Table II presents the number of banks
in sample by country and group.
2.2. Variables
Table III presents the variables used in the
models as criteria of banks soundness. Credit
agencies, auditors and bank regulators tend to
evaluate banks performance on the basis of
the CAMEL model that stands for the acronyms
of Capital, Asset quality, Management, Earnings
and Liquidity. We follow the same approach
and select nancial variables that proxy for the
four of the ve dimensions, as well as size.
Management has not been included in the analysis
due to its qualitative nature and the subjective
analysis that is required. Credit agencies point out
that during their rating they consider various
non-nancial characteristics such as the environ-
ment in which banks operate, ownership and
franchise power. Consequently, we use additional
non-nancial variables to proxy for these
characteristics.
Table I. Denitions of Fitchs bank individual ratings
Fitch
rating
Coded in the
present study
Denition
A Group 1 A very strong bank. Characteristics may include outstanding protability and balance sheet
integrity, franchise, management, operating environment or prospects
B Group 1 A strong bank. There are no major concerns regarding the bank. Characteristics may include
strong protability and balance sheet integrity, franchise, management, operating environment or
prospects
C Group 2 An adequate bank, which, however, possesses one or more troublesome aspects. There may be
some concerns regarding its protability and balance sheet integrity, franchise, management,
operating environment or prospects
D Group 3 A bank, which has weaknesses of internal and/or external origin. There are concerns regarding its
protability and balance sheet integrity, franchise, management, operating environment or
prospects. Banks in emerging markets are necessarily faced with a greater number of potential
deciencies of external origin
E Group 3 A bank with very serious problems, which either requires or is likely to require external support
Note: Fitch also uses the following intermediate assignments among the major ve categories: A/B, B/C, C/D, D/E.
4
Using Bankscope has two main advantages. First, it
has information for a very large number of banks,
accounting for about 90% of total assets in each country
(Claessens et al., 2001). Second, and most important, the
nancial information at the bank level is presented in
standardized formats, after adjusting for dierences in
accounting and reporting standards. The data compiled
by Bankscope use nancial statements and notes found
in audited annual reports. Each country in the Bank-
scope database has its own data template, thus allowing
for dierences in the reporting and accounting conven-
tions. The data are then converted to a global format
using a globally standardized template derived from the
country-specic templates. The global format also
provides standard nancial ratios, which can be
compared across banks and between countries. There-
fore, Bankscope is the most comprehensive database
that allows cross-country comparisons (Claessens et al.,
2001).
A MULTICRITERIA DECISION FRAMEWORK 105
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda
T
a
b
l
e
I
I
.
B
a
n
k
s
b
y
c
o
u
n
t
r
y
a
n
d
r
i
s
k
g
r
o
u
p
G
r
o
u
p
1
G
r
o
u
p
2
G
r
o
u
p
3
G
r
o
u
p
1
G
r
o
u
p
2
G
r
o
u
p
3
G
r
o
u
p
1
G
r
o
u
p
2
G
r
o
u
p
3
A
r
g
e
n
t
i
n
a
0
0
4
H
o
n
g
K
o
n
g
1
0
8
0
P
h
i
l
i
p
p
i
n
e
s
0
6
8
A
u
s
t
r
a
l
i
a
8
1
0
H
u
n
g
a
r
y
0
1
1
P
o
l
a
n
d
0
2
4
A
u
s
t
r
i
a
2
0
0
I
c
e
l
a
n
d
0
2
0
P
o
r
t
u
g
a
l
6
3
0
A
z
e
r
b
a
i
j
a
n
0
0
1
I
n
d
i
a
0
6
2
0
Q
a
t
a
r
1
2
0
B
a
h
r
a
i
n
1
1
0
I
n
d
o
n
e
s
i
a
0
5
7
R
o
m
a
n
i
a
0
0
3
B
a
n
g
l
a
d
e
s
h
0
0
3
I
r
e
l
a
n
d
6
0
0
R
u
s
s
i
a
n
F
e
d
e
r
a
t
i
o
n
0
2
2
3
B
e
l
a
r
u
s
0
0
2
I
s
r
a
e
l
0
2
1
S
a
u
d
i
A
r
a
b
i
a
7
0
1
B
e
l
g
i
u
m
7
0
0
I
t
a
l
y
1
1
1
5
1
S
i
n
g
a
p
o
r
e
4
0
0
B
e
n
i
n
0
1
0
J
a
p
a
n
1
6
1
7
S
l
o
v
e
n
i
a
1
5
0
B
r
a
z
i
l
0
9
1
J
o
r
d
a
n
2
1
0
S
o
u
t
h
A
f
r
i
c
a
5
3
0
B
u
l
g
a
r
i
a
0
2
1
K
a
z
a
k
h
s
t
a
n
0
1
5
S
p
a
i
n
4
4
4
1
C
a
n
a
d
a
6
1
0
K
e
n
y
a
0
0
4
S
r
i
L
a
n
k
a
0
0
5
C
h
i
l
e
3
1
0
K
o
r
e
a
(
R
e
p
u
b
l
i
c
o
f
)
2
7
2
S
w
e
d
e
n
7
0
0
C
h
i
n
a
0
0
1
4
K
u
w
a
i
t
2
6
0
S
w
i
t
z
e
r
l
a
n
d
5
1
0
C
r
o
a
t
i
a
0
1
0
L
a
t
v
i
a
0
1
1
T
a
i
w
a
n
5
6
1
0
C
y
p
r
u
s
0
3
1
L
e
b
a
n
o
n
0
2
0
T
h
a
i
l
a
n
d
0
4
6
C
z
e
c
h
R
e
p
u
b
l
i
c
0
2
0
L
i
t
h
u
a
n
i
a
0
1
3
T
u
n
i
s
i
a
0
0
2
D
e
n
m
a
r
k
5
0
0
L
u
x
e
m
b
o
u
r
g
2
0
0
T
u
r
k
e
y
0
5
1
9
D
o
m
i
n
i
c
a
n
R
e
p
u
b
l
i
c
0
0
2
M
a
l
a
y
s
i
a
2
5
4
U
k
r
a
i
n
e
0
0
4
E
g
y
p
t
0
1
1
M
a
l
t
a
0
1
1
U
n
i
t
e
d
A
r
a
b
E
m
i
r
a
t
e
s
1
5
0
E
l
S
a
l
v
a
d
o
r
0
1
4
M
e
x
i
c
o
2
6
1
U
n
i
t
e
d
K
i
n
g
d
o
m
4
2
4
0
E
s
t
o
n
i
a
1
0
0
N
e
t
h
e
r
l
a
n
d
s
9
2
1
U
S
A
2
1
9
2
2
4
F
i
n
l
a
n
d
3
0
0
N
e
w
Z
e
a
l
a
n
d
3
0
0
V
e
n
e
z
u
e
l
a
0
0
8
F
r
a
n
c
e
1
3
9
0
N
o
r
w
a
y
8
0
0
V
i
e
t
n
a
m
0
0
4
G
e
o
r
g
i
a
(
R
e
p
.
o
f
)
0
0
2
O
m
a
n
0
4
0
T
o
t
a
l
4
6
6
2
1
4
2
1
4
G
e
r
m
a
n
y
7
1
9
2
P
a
k
i
s
t
a
n
0
0
4
G
r
e
e
c
e
3
2
0
P
a
n
a
m
a
0
4
1
C. GAGANIS ET AL. 106
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda
2.2.1. Financial variables. CAP is the equity to
total assets ratio that serves as a measure of capital
strength.
5
PROVIS is the loan loss provisions to
net interest revenue ratio that is a measure of asset
quality. ROAA is the return on average assets that
is a classical measure of protability. EXPENSES
is the cost-to-income ratio
6
that reveals the
eciency in managing expenses. LIQ corresponds
to the liquid assets
7
to customer and short-term
funding ratio that shows the percentage of
customer and short-term funding that could be
met if they were withdrawn suddenly. SIZE is the
logarithm of total assets and is a measure of size.
2.2.2. Non-nancial variables. SUBS is the number
of subsidiaries that is used as a proxy for the
diversication of business and franchise. OWNERS
is the number of institutional shareholders, and
LIST is a dummy variable indicating whether the
bank is listed on a stock exchange (LIST 1) or not
(LIST 0). Both variables are used as proxies of
corporate governance and ownership. Our last
variable is a dummy variable indicating whether
the banks operate in a developed (MARKET 1)
or developing (MARKET 0) market.
3. METHODOLOGY
The most common approach to address multi-
criteria classication problems is to develop a
criteria aggregation model based on absolute
judgements, which provides a rule for the classi-
cation of the alternatives on the basis of their
comparison with some reference proles (cut-o
points) that distinguish the classes. Following this
approach, the objective of the UTADIS method is
to develop a classication model in the form of an
additive value function.
Vx
X
n
i1
w
i
v
i
x
i

where x x
1
; x
2
; . . . ; x
n
is the vector of decision
attributes (nancial ratios), w
1
; w
2
; . . . ; w
n
are
attributes weights dened such that w
i
50 and
P
i
w
i
1, and v
1
; v
2
; . . . ; v
n
are the attributes
marginal value functions normalized in [0, 1].
Each marginal value function, v
i
, is used to assess
the partial performance of each bank in attribute
x
i
in an increasing 01 scale.
Given the global values of the banks as dened
by the estimated additive value function, their
classication into q groups C
1
; C
2
; . . . ; C
q
can be
performed in a straightforward way through the
introduction of q1 value cut-o points
t
1
; t
2
; . . . ; t
q1
, such that
Vx
i
5t
1
, bank i belongs to group C
1
t
2
4Vx
i
5t
1
, bank i belongs to group C
2
.
.
.
.
.
.
Vx
i
5t
q1
,bank i belongs to group C
q
The estimation of the additive value function
and the cut-o thresholds is performed through
linear programming techniques. The objective of
the method is to develop the additive value model
so that the above classication rules can reproduce
the predetermined grouping of the banks as
accurately as possible. Therefore, a linear pro-
gramming formulation is employed to minimize
Table III. List of criteria (variables)
Financial
CAP Equity/total assets
PROVIS Loan loss provisions/net interest revenue
ROAA Return on average assets
EXPENSES Cost-to-income ratio
LIQ Liquid assets/customer and short-term funding
SIZE Logarithm of total assets
Non-nancial
SUBS The number of subsidiaries
OWNERS The number of institutional shareholders
LIST Dummy variable indicating whether the bank
is listed (LIST 1) in a stock exchange or not
(LIST 0)
MARKET Dummy variable indicating whether the bank
is operating in a developed (MARKET 1) or
developing (MARKET 0) market
5
Probably, the employment of a risk-weighted ratio
such as the Tier 1 ratio would be more appropriate.
However, due to too many missing values for Tier 1, we
rely on EQAS that is considered one of the basic ratios
whose use dates back to the 1900s, and is still being used
in many recent studies in banking.
6
Cost refers to overheads that are the expenses for
running business, such as sta salaries and benets, rent
expenses, equipment expenses and other administrative
expenses.
7
These are generally short-term assets that can be easily
converted into cash, such as cash itself, deposits with the
central bank, treasury bills, other government securities
and interbank deposits among others.
A MULTICRITERIA DECISION FRAMEWORK 107
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda
the sum of all violations of the above classication
rules for all the banks in the training sample.
Detailed description of the mathematical program-
ming formulation can be found in the works of
Zopounidis and Doumpos (1999) and Doumpos
and Zopounidis (2002).
4. EMPIRICAL RESULTS
Table IV shows descriptive statistics while distin-
guishing between the three groups of banks, as
well as between developed and developing mar-
kets. We also present the results of a Kruskal
Table IV. Descriptive statistics and KruskalWallis test (total sample): (A) Continuous variables and (B)
Categorical variables (no.)
1 2 3
Mean Std. Deviation Mean Std. Deviation Mean Std. Deviation KruskalWallis
chi-square
(A)
SIZE
Total 4.388 0.669 3.843 0.689 3.535 0.865 188.992
***
Developed 4.398 0.678 4.010 0.764 4.462 0.885 26.279
***
Developing 4.221 0.506 3.650 0.529 3.328 0.713 50.538
***
PROVIS
Total 13.664 15.556 23.103 21.500 32.198 39.085 85.516
***
Developed 13.568 15.889 25.612 22.730 52.776 55.357 61.67
***
Developing 15.172 8.877 20.190 19.691 27.612 32.936 7.58
**
CAP
Total 8.159 3.690 9.297 4.874 9.443 6.099 6.51
**
Developed 8.019 3.654 7.970 4.612 5.543 3.962 27.919
***
Developing 10.353 3.615 10.838 4.735 10.312 6.159 4.127
ROAA
Total 1.189 0.740 1.124 1.043 1.231 1.609 3.652
Developed 1.152 0.715 0.589 0.669 0.061 0.772 121.639
***
Developing 1.763 0.899 1.746 1.056 1.492 1.632 11.268
***
EXPENSES
Total 57.054 13.241 57.105 15.577 57.891 18.599 0.551
Developed 57.625 12.921 62.432 14.597 57.708 17.537 11.503
***
Developing 48.131 15.148 50.918 14.406 57.932 18.876 12.365
***
LIQ
Total 19.588 19.473 28.024 21.329 30.632 19.763 82.258
***
Developed 18.666 19.198 25.675 23.702 15.611 17.039 11.591
***
Developing 34.014 18.322 30.752 17.923 33.979 18.785 3.098
OWNERS
Total 5.711 7.255 5.171 6.074 5.537 5.690 9.226
**
Developed 5.768 7.368 5.736 7.230 5.205 6.127 2.742
Developing 4.821 5.193 4.515 4.310 5.611 5.604 2.021
SUBS
Total 91.983 195.844 32.808 85.374 17.551 68.655 114.935
***
Developed 96.572 200.980 49.574 112.187 64.359 152.735 6.737
**
Developing 20.214 33.317 13.333 22.096 7.120 8.649 14.017
***
(B)
LIST 1 2 3
Total 466 214 214
Developed 438 115 39
Developing 28 99 175
Notes:
***
Signicant at the 1% level;
**
signicant at the 5% level;
*
signicant at the 10% level; variables are dened in Table III.
C. GAGANIS ET AL. 108
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda
Wallis test to assess the means dierences across
the groups.
SIZE, PROVIS and SUBS are the only variables
that are statistically signicant in all cases.
However, while higher size results in higher
soundness in the cases of the total sample and
the developing markets sub-sample, the results are
mixed in the case of the developed markets sub-
sample, with an average SIZE equal to 4.398
(Group 1), 4.010 (Group 2) and 4.462 (Group 3).
Lower PROVIS results in higher soundness which
can be attributed to the perception that lower
provisions correspond to lower probability of
non-performing loans and higher asset quality.
As in the case of SIZE, the impact of SUBS on
soundness depends on the status of the market.
CAP and LIQ are signicant in the case of the
total sample and in developed countries, although
not in developing countries. ROAA and EX-
PENSES on the other hand are signicant in the
case of the two sub-samples, although not in
the case of the total sample. Higher ROAA results
in higher soundness, however, the results are
mixed with respect to EXPENSES. Finally, OWN-
ERS is signicant only in the case of the total
sample.
Table V presents the average weights of the
criteria over the 10 replications. The two most
important criteria are PROVIS and CAP, with
weights equal to 20 and 19.76%, respectively.
Hence, as in previous studies (Poon et al., 1999;
Poon and Firth, 2005; Pasiouras et al., 2006) and
consistent with the univariate results, lower asset
quality (in terms of loan portfolio) results in lower
soundness. As for CAP, our nding is consistent
with the view that capital is important for banks
for several reasons. For example, capital serves as
the last line of defence against the risk of banks
insolvency, as any losses a bank suers could be
potentially written o against capital. Even in the
case that insolvency becomes unavoidable, capital
protects to some degree depositors, creditors and
investors (Le Bras and Andrews, 2004). Further-
more, as mentioned by Theodore (1999) capital
allows the leveraging of a banks growth and
diversication, and a tight solvency position would
be an obstacle to do so.
The average weight of MARKET equals
15.66% showing that the country where the
banks operate has an important impact on their
classication. In other words, we nd that operat-
ing in a developed market results in higher
soundness. EXPENSES and ROAA also carry
an average weight above 10%, indicating that
higher eciency in expenses management and
higher protability result in higher bank sound-
ness. The least important variables are SIZE and
LIST. Especially, the latter carries an average
weight equal to 0%, indicating that it makes no
dierence whether the bank is listed in a stock
exchange or not.
Table VI presents the average classication
accuracies over the 10 replications. Panel A
corresponds to the training sample and Panel B
to the validation sample. For benchmarking
purposes, two additional models are developed
through DA and ordinary logistic regression
(OLR) using the same input variables and 10-fold
cross-validation process for estimating and testing
the models.
UTADIS obtains the highest overall classica-
tion accuracy in the training sample that equals
Table V. Weights of criteria (variables) in the UTADIS
model (averages of 10 replications)
Criteria (variables) Weights (%)
PROVIS 20.00
CAP 19.76
MARKET 15.66
EXPENSES 10.31
ROAA 10.21
LIQ 9.08
OWNERS 8.79
SUBS 4.58
SIZE 1.60
LIST 0.00
Note: Variables are dened in Table III.
Table VI. Classication results (averages over 10
replications): (A) Training and (B) Validation
Group
1 (%) 2 (%) 3 (%) Overall (%)
(A)
UTADIS 84.10 53.89 74.54 70.84
OLR 92.63 24.02 73.37 63.34
DA 90.17 27.1 79.78 65.68
(B)
UTADIS 83.47 50.49 72.75 68.91
OLR 92.63 23.33 72.68 62.88
DA 90.48 26.22 78.47 65.06
Notes: UTADIS, UTilite s Additives DIScriminantes; OLR,
ordinary logistic regression; DA, discriminant analysis.
A MULTICRITERIA DECISION FRAMEWORK 109
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda
70.84%, while the corresponding gures for DA
and OLR are 65.58 and 63.34%, respectively. All
the three models classify correctly a high propor-
tion of banks from Group 1 that ranges between
84.19% (UTADIS) and 92.63% (OLR), followed
by banks in Group 3, but only a relatively smaller
proportion of banks in Group 2 that is between
24.02% (OLR) and 53.89% (UTADIS). The poor
performance in terms of classifying banks into
intermediate groups has been observed in past
studies as well (e.g. Pasiouras et al., 2007) and can
be attributed to the fact that banks falling in this
category might be closely related either to banks in
the lower band of Group 1 or the upper band of
Group 3, hence making their correct classication
a dicult task. The results of a t-test, used to
assess the dierences in the classication accura-
cies among the methods, indicate that the accura-
cies achieved by UTADIS are signicantly
dierent from the ones obtained by DA and
OLR at the 1% level.
Turning to the accuracies in the validation data
set, the highest overall accuracy (68.91%) is again
achieved by UTADIS, with group accuracies equal
to 83.47% (Group 1), 50.49% (Group 2) and
72.75% (Group 3). OLR and DA classify correct
62.88 and 65.06% of the banks in sample (i.e.
overall). As in the case of the training sample, all
three models classify correctly a higher proportion
of banks from Groups 1 and 3, and a relatively
lower proportion of banks from Group 2. The
dierence between UTADIS and DA is now
statistically signicant at the 5% level, whereas
the one between UTADIS and OLR remains
signicant at the 1% level.
5. CONCLUSIONS
In this paper, we developed a multicriteria model,
through UTADIS, to classify banks into three
groups on the basis of their soundness. The sample
consisted of 894 banks from 79 countries. The
model was developed through a 10-fold cross-
validation procedure using six nancial and four
non-nancial variables, while the ratings of Fitch
formed the basis for assessing the soundness of
banks.
The results indicate that asset quality (as
measured by loan loss provisions), capitalization
and the market where banks operate are the most
important criteria (in terms of weights) in classify-
ing the banks. Protability and eciency in
expenses management are also important attri-
butes, whereas size and listing in a stock exchange
are the least important ones.
UTADIS classied correctly 70.84 and 68.91%
of the banks in training and validation samples
accordingly, and was more ecient than models
developed through DA and OLR for benchmark-
ing purposes. Furthermore, the dierences in the
classication accuracies achieved by UTADIS and
the ones obtained by DA and OLS were statisti-
cally signicant in both the training and the
validation samples. Finally, all the techniques
experienced diculties in classifying banks in
intermediate situation.
The present study could be extended in various
ways, such as the classication of banks into more
groups, and the inclusion of additional bank-
specic variables into the model. It would also be
worthwhile to incorporate further country-specic
variables into the analysis, reecting the regulatory
and economic environment in the markets where
banks operate. Finally, one could benchmark the
developed model against the alternative classica-
tion techniques or develop integrated models.
ACKNOWLEDGEMENTS
We would like to thank two reviewers, and
participants at the 18th International Conference
on Multiple Criteria Decision Making (2006) for
helpful comments and suggestions that helped us
improve earlier versions of the paper circulated
under the title An assessment of banks credit-
worthiness: a multicriteria approach.
REFERENCES
Aldrich JH, Nelson FD. 1984. Linear Probability, Logit,
and Probit Models. Sage Publication: CA.
Barniv R, McDonald JB. 1999. Review of categorical
models for classication issues in accounting and
nance. Review of Quantitative Finance and Account-
ing 13: 3962.
Belkaoui A. 1983. Industrial Bonds and the Rating
Process. Greenwood Press: Westport.
Canbas S, Cabuk A, Kilic SB. 2005. Prediction of
commercial bank failure via multivariate statistical
analysis of nancial structures: the Turkish case.
European Journal of Operational Research 166:
528546.
Claessens S, Demirgu c -Kunt A, Huizinga H. 2001. How
does foreign entry aect domestic banking markets?
Journal of Banking and Finance 25(5): 891911.
C. GAGANIS ET AL. 110
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda
Cole RA, Gunther JW. 1998. Predicting bank failures:
a comparison of on- and o-site monitoring
systems. Journal of Financial Services Research 13(2):
103117.
Demirguc-Kunt A, Detragiache E, Tressel T. 2006.
Banking on the principles: compliance with Basel core
principles and bank soundness. World Bank Policy
Research Working Paper 3954, June.
Doumpos M, Zopounidis C. 2002. Multicriteria Deci-
sion Aid Classication Methods. Kluwer Academic
Publishers: Dordrecht.
Ederington L, Yawitz JB, Roberts BE. 1987. The
information content of bond rating. The Journal of
Financial Research 10(3): 211226.
Frecka TJ, Hopwood WS. 1983. The eects of outliers
on the cross-sectional distributional properties of
nancial ratios. The Accounting Review 58: 115128.
Hammer PL, Kogan A, Lejeune MA. 2006. Modeling
country risk ratings using partial orders. European
Journal of Operational Research 175: 836859.
Hopwood WS, McKeown JC, Mutchler JF. 1988. The
sensitivity of nancial distress prediction models to
departures from normality. Contemporary Accounting
Research 5: 284298.
Horrigan JO. 1966. The determination of long-term
credit standing with nancial ratios. Journal of
Accounting Research 4: 4462.
Huang Z, Chen H, Hsu Ch-J, Chen W-H, Wu S. 2004.
Credit rating analysis with support vector machines
and neural networks: a market comparative study.
Decision Support Systems 37: 543558.
Kaplan RS, Urwitz G. 1979. Statistical models of bond
ratings: a methodological inquiry. Journal of Business
52: 231261.
Kim JW. 1993. Expert systems for bond rating: a
comparative analysis of statistical, rule-based
and neural networks systems. Expert Systems 10:
167171.
Kolari J, Glennon D, Shin H, Caputo M. 2002.
Predicting large US commercial bank failures. Journal
of Economics and Business 54: 361387.
Kosmidou K, Zopounidis C. 2007. Predicting US
commercial bank failures via a multicriteria approach.
International Journal of Risk Assessment and Manage-
ment, in press.
Lanine G, Vander Vennet R. 2006. Failure prediction in
the Russian bank sector with logit and trait recogni-
tion models. Expert Systems with Applications 30:
463478.
Le Bras A, Andrews D. 2004. Bank Rating Methodology:
Criteria Report, 25 May, FitchRatings. Available at
www.tchratings.com
Mar-Molinero C, Serrano-Cinca C. 2001. Bank failure:
a multidimensional scaling approach. The European
Journal of Finance 7: 165183.
Noreen E. 1988. An empirical comparison of probit and
OLS regression hypothesis tests. Journal of Account-
ing Research 26: 119133.
Pantalone C, Platt MB. 1987. Predicting commercial
bank failure since deregulation. New England Eco-
nomic Review 13: 3747.
Pasiouras F, Gaganis Ch, Doumpos M. 2007. A multi-
criteria discrimination approach for the credit rating of
Asian banks. Annals of Finance 3: 351367.
Pasiouras F, Gaganis Ch, Zopounidis C. 2006. The
impact of bank regulations, supervision, market
structure and bank characteristics on individual bank
ratings: a cross-country analysis. Review of Quantita-
tive Finance and Accounting 27(4): 403438.
Pinches GE, Mingo KA. 1973. A multivariate analysis of
industrial bond ratings. Journal of Finance 28: 118.
Poon WPH, Firth M. 2005. Are unsolicited credit
ratings lower? International evidence from bank
ratings. Journal of Business Finance and Accounting
32(9 & 10): 17411771.
Poon WPH, Firth M, Fung H-G. 1999. A multivariate
analysis of the determinants of Moodys bank
nancial strength ratings. Journal of International
Financial Markets, Institutions and Money 9: 267283.
Ravi Kumar P, Ravi V. 2007. Bankruptcy prediction in
banks and rms via statistical and intelligent techni-
ques}a review. European Journal of Operational
Research 180: 128.
Richardson FM, Davidson LF. 1984. On linear dis-
crimination with accounting ratios. Journal of Busi-
ness Finance and Accounting 11: 511525.
Rose PS, Kolari JW. 1985. Early warning systems as a
monitoring device for bank condition. Quarterly
Journal of Business and Economics 24(Winter): 4360.
Sinkey J. 1975. A multivariate statistical analysis of the
characteristics of problem banks. Journal of Finance
30: 2136.
Stone M, Rasp J. 1991. Tradeo in the choice between
logit and OLS for accounting choice studies. The
Accounting Review 66: 170187.
Tam KY, Kiang MY. 1992. Managerial applications of
neural networks: the case of bank failure predictions.
Management Science 38(7): 926947.
Theodore SS. 1999. Bank Credit Risk Rating Methodol-
ogy (An Analytical Framework for Banks in Developed
Markets), Moodys Investors Service, Global Credit
Research, April.
Thomson JB. 1991. Predicting bank failure in the 1980s.
Economic Review, Federal Reserve Bank of Cleveland,
Volume Q1: 920.
Tung WL, Quek C, Cheng P. 2004. GenSo-EWS: a novel
neural-fuzzy based early warning system for predicting
bank failures. Neural Networks 17: 567587.
Yim J, Mitchell H. 2005. Comparison of country risk
models: hybrid neural networks, logit models, dis-
criminant analysis and cluster techniques. Expert
Systems with Applications 28(1): 137148.
Zopounidis C, Doumpos M. 1999. A multicriteria
decision aid methodology for sorting decision pro-
blems: the case of nancial distress. Computational
Economics 14: 197218.
A MULTICRITERIA DECISION FRAMEWORK 111
Copyright # 2007 John Wiley & Sons, Ltd. J. Multi-Crit. Decis. Anal. 14: 103111 (2006)
DOI: 10.1002/mcda