Application of multiple discriminant analysis (MDA) as a credit scoring and risk assessment model

Purpose - The purpose of this research is to investigate whether inclusion of risk assessment variables in the multiple discriminant analysis (MDA) model improved the banks ability in making correct customer classification, predict firm's performance and credit risk assessment. Design/methodology/approach - The paper reviews literature on the application of financial distress and credit scoring methods, and the use of risk assessment variables in classification models. The study used a sample of 56 performing and non-performing assets (NPA) of a privatized commercial bank in Tanzania. Financial ratios were used as independent variables for building the MDA model with a variation of five MDA models. Different statistical tests for normality, equality of covariance, goodness of fit and multi-colinearity were performed. Using the estimation and validation samples, test results showed that the MDA base model had a higher level of predictability hence classifying correctly the performing and NPA with a correctness of 92.9 and 96.4 percent, respectively. Lagging the classification two years, the results showed that the model could predict correctly two years in advance. When MDA was used as a risk assessment model, it showed improved correct customer classification and credit risk assessment. Findings - The findings confirmed financial ratios as good classification and predictor variables of firm's performance. If the bank had used the MDA for classifying and evaluating its customers, the probability of failure could have been known two years before actual failure, and the misclassification costs could have been calculated objectively. In this way, the bank could have reduced its non-performing loans and its credit risk exposure. Research limitations/implications - The valiadation sample used in the study was smaller compared to the estimation sample. MDA works better as a credit scoring method in the banking environment two years before and after failure. The study was done on the current financial crisis of 2009. Practical implications - Use of MDA helps banks to determine objectively the misclassification costs and its expected misclassification errors plus determining the provisions for bad debts. Banks could have reduced the non-performing loans and their credit risks exposure if they had used the MDA method in the loan-evaluation and classification process. The study has proved that quantitative credit scoring models improve management decision making as compared to subjective assessment methods. For improved credit and risk assessment, a combination of both qualitative and quantitave methods should be considered. Originality/value - The findings have shown that using the MDA, commercial banks could have improved their objective decision making by correctly classifying the credit worthiness of a customer, predicting firm's future performance as well as assessing their credit risk. It has also shown that other than financial variables, inclusion of stability measures improves management decision making and objective provisioning of bad debts. The recent financial crisis emphasizes the need for developing objective credit scoring methods and instituting prudent risk assessment culture to limit the extent and potential of failure.