CART-based selection of bankruptcy predictors for the logit model

Balance-sheet data offer a potentially large number of candidate predictors of corporate financial failure. In this paper we provide a novel predictor selection procedure based on non-parametric regression and classification tree method (CART) and test its performance within a standard logit model. We show that a simple logit model with dummy variables created in accordance with the nodes of estimated classification tree outperforms both standard logit model with step-wise-selected financial ratios, and CART itself. On a population of Slovenian companies our method achieves remarkable rates of precision in out-of-sample bankruptcy prediction. Our selection method thus represents an efficient way of introducing non-linear effects of predictor variables on the default probability in standard single-index models like logit. These findings are robust to choice-based sampling of estimation samples. (c) 2012 Elsevier Ltd. All rights reserved.