On building early-warning systems for preventing the deterioration of financial institutions’ performance

Abstract

Abstract This paper assesses the financial performance of Romania’s non-banking financial institutions (NFIs) using a neural network training algorithm proposed by Kohonen, namely the Self-Organizing Maps algorithm. The algorithm takes the financial dataset and positiones each observation into a self-organizing map (a two-dimensional map) which can be latter used to visualize the trajectories of an individual NFI and explain it based on different performance dimensions, such as capital adequacy, assets’ quality and profitability. Further, we use the map as an early-warning system that would accurately forecast the NFIs future performance (whether they would stay or be eliminated from the NFI’s Special Register three quarters into the future). The results are promising: the model is able to correctly predict NFIs’ performance movements. Finally, we compared the results of our SOM-based model with those obtained by applying a multivariate logit-based model. The SOM model performed worse in discriminating the NFIs’ performance: the performance classes were not clearly defined and the model lacked the interpretability of the results. In the contrary, the multivariate logit coefficients have nice interpretability and an individual default probability estimate is obtained for each new observation. However, we can benefit from the results of both techniques: the visualization capabilities of the SOM model and the interpretability of multivariate logit-based model.