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Extracting Leading Indicators of Bank Fragility from Market Prices – Estonia Focus

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  • Yu-Fu Chen
  • Michael Funke
  • Kadri Männasoo

Abstract

Banking reform has proved to be one of the most problematic elements of economic transition in central and Eastern Europe. Therefore the paper considers the development of the Estonian banking sector and derives individual banks´ fragility scores during transition. To this end we use option-based tools and equity prices to estimate distance-to-default measures of banks´ distress probabilities. Overall, the results suggest that market indicators are moderately useful for anticipating future financial distress and rating changes in transition economies. The implication for an effective supervisory framework is to use a plurality of risk scores when assessing bank vulnerability.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1647.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1647

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Keywords: banking; financial stability; bank fragility; options; Estonia;

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  1. Jeffery W. Gunther & Mark E. Levonian & Robert R. Moore, 2001. "Can the stock market tell bank supervisors anything they don't already know?," Economic and Financial Policy Review, Federal Reserve Bank of Dallas, Federal Reserve Bank of Dallas, issue Q II, pages 2-9.
  2. Reint Gropp & Jukka Vesala & Giuseppe Vulpes, 2004. "Market indicators, bank fragility, and indirect market discipline," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Sep, pages 53-62.
  3. Xavier Freixas & Bruno Parigi & Jean Charles Rochet, 1998. "Systemic risk, interbank relations and liquidity provision by the Central Bank," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 440, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 1999.
  4. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
  5. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers, Massachusetts Institute of Technology (MIT), Sloan School of Management 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  6. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2002. "Equity and bond market signals as leading indicators of bank fragility," Working Paper Series, European Central Bank 0150, European Central Bank.
  7. Alain Bensoussan & Michel Crouhy & Dan Galai, 1994. "Stochastic equity volatility related to the leverage effect," Applied Mathematical Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 1(1), pages 63-85.
  8. Asli Demirgüç-Kunt & Enrica Detragiache, 2005. "Cross-Country Empirical Studies of Systemic Bank Distress: A Survey," IMF Working Papers 05/96, International Monetary Fund.
  9. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
  10. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  11. Arnaud Jobert & Janet Kong & Jorge A. Chan-Lau, 2004. "An Option-Based Approach to Bank Vulnerabilities in Emerging Markets," IMF Working Papers 04/33, International Monetary Fund.
  12. Crouhy, Michel & Galai, Dan & Mark, Robert, 2000. "A comparative analysis of current credit risk models," Journal of Banking & Finance, Elsevier, Elsevier, vol. 24(1-2), pages 59-117, January.
  13. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  14. Bongini, Paola & Laeven, Luc & Majnoni, Giovanni, 2002. "How good is the market at assessing bank fragility? A horse race between different indicators," Journal of Banking & Finance, Elsevier, Elsevier, vol. 26(5), pages 1011-1028, May.
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Cited by:
  1. Casu, Barbara & Clare, Andrew & Saleh, Nashwa, 2011. "Towards a new model for early warning signals for systemic financial fragility and near crises: an application to OECD countries," MPRA Paper 37043, University Library of Munich, Germany.
  2. Forges, Françoise & Koessler, Frédéric, 2008. "Long persuasion games," Journal of Economic Theory, Elsevier, Elsevier, vol. 143(1), pages 1-35, November.
  3. Eichler, Stefan & Karmann, Alexander & Maltritz, Dominik, 2010. "Deriving the term structure of banking crisis risk with a compound option approach: The case of Kazakhstan," Discussion Paper Series 2: Banking and Financial Studies 2010,01, Deutsche Bundesbank, Research Centre.
  4. Boris Blagov, 2013. "Financial crises and time- varying risk premia in a small open economy: a Markov-Switching DSGE model for Estonia," Bank of Estonia Working Papers, Bank of Estonia wp2013-8, Bank of Estonia, revised 09 Dec 2013.

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