Distance-to-default in banking: A bridge too far?

Abstract

This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.In contrast to corporate defaults, regulators typically take a number of statutory actions to avoid the large fiscal costs associated with bank defaults. The distance-to-default, a widely used market-based measure of corporate default risk, ignores such regulatory actions. To overcome this limitation, this paper introduces the concept of distance-to-capital that accounts for pre-default regulatory actions such as those in a prompt-corrective-actions framework. We show that both risk measures can be analyzed using the same theoretical framework but differ depending on the level of capital adequacy thresholds and asset volatility. We also use the framework to illustrate pre-default regulatory actions in Japan in 2001-03. JEL Classification Numbers: G12, G21

An Empirical Study on the Impact of Basel III Standards on Banks’ Default Risk: The Case of Luxembourg

“…The economic and finance literature provides several measures of probability of default linked to credit risk (see, e.g., Merton 1974, Duffie and Singleton 2003, Campbell et al 2008, Basurto and Espinoza 2011, Chan-Lau and Sy 2007, and for applications to Luxembourg, see Jin and Nadal de Simone October 2011). In this study, we resort to the Z-score index as the measure of bank distance-to-default 7 , which has increasingly been used in the academic literature (see, e.g., DeNicolo 2001, DeNicolo et al 2004, Berger et al 2009, Wolff and Papanikolaou 2015, Maechler et al 2007).…”

Distance to default, subordinated debt, and distress indicators in the banking industry*

“…, 2004, 2006; Akhigbe et al. , 2007; Chan‐Lau and Sy, 2007; Duffie et al. , 2007; Bharath and Shumway, 2008; Campbell et al.…”

Systemic Risk Analysis Using Forward-Looking Distance-to-Default Series

“…The potential to use aggregated DD series to also monitor systemic risk is not negligible and, in the case of the European and other mature banking 4 Additional methodological drawbacks not tackled in this paper include the assumption of an ad-hoc default barrier, constant interest rates and constant volatility. Capuano (2008) tackles the first issue proposing an endogenously determined default barrier that rapidly incorporates market sentiment about the developments of the balance sheets, while Chan-Lau and Sy (2006) introduce modifications in the ad-hoc default barrier to capture pre-default regulatory actions, such as Prompt-Corrective-Actions frameworks, a common feature in the case of financial institutions. Findings in Echeverría et al (2009) show that the choice of risk-free interest rates does not affect the estimates of DD significantly but their selection has to be adjusted to the specificities of the institutions and markets of analysis (see Blavy and Souto (2009) for a detailed discussion in the case of the Mexican banking system).…”