Anticipating bank distress in the Eurozone: An Extreme Gradient Boosting approach

The banking sector plays a special role in the economy and has critical functions which are essential for economic stability. Hence, systemic banking crises disrupt financial markets and hinder global economic growth. In this study, Extreme Gradient Boosting, a state of the art machine learning method, is applied to identify a set of key leading indicators that may help predict and prevent bank failure in the Eurozone banking sector. The cross-sectional data used in this study consists of 25 annual financial ratio series for commercial banks in the Eurozone. The sample includes Eurozone listed failed and non-failed banks for the period 2006–2016. A number of early warning systems and leading indicator models have been developed to prevent bank failure. Yet the breadth and depth of the recent financial crisis indicates that these methods must improve if they are to serve as a useful tool for regulators and managers of financial institutions. Our goal is to build a classification model to determine which variables should be monitored to anticipate bank financial distress. A set of key variables are identified to anticipate bank defaults. Identifying leading indicators of bank failure is necessary so that regulators and financial institutions' management can take preventive and corrective measures before it is too late.