How Early Can Non-Performance Loan Predict Bank Failure? Evidence from US Bank Failure during 2008-2010

Abstract

Probit model was applied on the non-performance loans (NPL) of eight quarters, quarter 1— quarter 8, in determining the significant quarter before the bank was declared failure. The result of the Probit estimates found that as early as one-year ahead (4^th quarter-ahead) bank-failure can be alerted and predicted. The NPL of the 4^th quarter was a significant predictor of bank failure. The estimates of the model correctly predicts 89.6 percent of the U.S. banks that failed and 97.6 percent of the banks that survived during 2008-2010. Overall, the estimated model correctly predicts 95.5 percent of the observations (89.6 percent of the failure =0 and 97.6 percent of the survival=1 observations).

The paper provides policy prescription that bank managements and bank regulators should pay attention to the early quarter(s) that are significant factor (s) for bank failure.