Bankruptcy prediction modeling with hybrid case-based reasoning and genetic algorithms approach

One of the most important research issues in finance is building effective corporate bankruptcy prediction models because they are essential for the risk management of financial institutions. Researchers have applied various data-driven approaches to enhance prediction performance including statistical and artificial intelligence techniques, and many of them have been proved to be useful. Case-based reasoning (CBR) is one of the most popular data-driven approaches because it is easy to apply, has no possibility of overfitting, and provides good explanation for the output. However, it has a critical limitation-its prediction performance is generally low. In this study, we propose a novel approach to enhance the prediction performance of CBR for the prediction of corporate bankruptcies. Our suggestion is the simultaneous optimization of feature weighting and the instance selection for CBR by using genetic algorithms (GAs). Our model can improve the prediction performance by referencing more relevant cases and eliminating noises. We apply our model to a real-world case. Experimental results show that the prediction accuracy of conventional CBR may be improved significantly by using our model. Our study suggests ways for financial institutions to build a bankruptcy prediction model which produces accurate results as well as good explanations for these results. (c) 2008 Elsevier B.V. All rights reserved.