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Distance-To-Default in Banking

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Author Info

  • Amadou N. R. Sy
  • Jorge A. Chan-Lau

Abstract

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.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/215.

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Length: 17
Date of creation: 01 Sep 2006
Date of revision:
Handle: RePEc:imf:imfwpa:06/215

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Related research

Keywords: Banks; Financial stability; capital adequacy; banking; capital adequacy ratio; bank capital; deposit insurance; bank regulators; capital adequacy ratios; bank defaults; capital regulation; banking sector; capital injection; bank problems; banking sector problems; bank supervisor; banking supervision; bank default; banking crises; capital ratio; equity capital; banking supervisors; bank classification; capital base; federal deposit insurance; bank intervention; bank closure; banking systems; option pricing; capital requirement; bank failures; bank supervisors; securities prices; minimum capital requirement; bank regulator; bank capital regulation; national bank; bank insolvency; banking law; bank regulation; bank distress; accounting treatment; bank failure; bank soundness; bank fragility; bank of canada; regional bank; bank equity; regulatory forbearance; bank data; problem bank; bank vulnerabilities; call options; bank for international settlements; bank run; bank conduct; capital asset ratios; bank interventions; moral hazard; bank insolvency regimes; capital asset; bank closures; bank of england;

References

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  1. Martin Cihák, 2006. "How Do Central Banks Writeon Financial Stability?," IMF Working Papers 06/163, International Monetary Fund.
  2. Raj Aggarwal & Kevin T. Jacques, 1998. "Assessing the impact of prompt corrective action on bank capital and risk," Economic Policy Review, Federal Reserve Bank of New York, issue Oct, pages 23-32.
  3. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  4. Larry Wall & Maria Nieto, 2006. "Precondition for a Successful Implementation of Supervisors' Primpt Corrective Action: Is There a Case for a Banking Standard in the EU?," FMG Special Papers sp165, Financial Markets Group.
  5. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2006. "Equity and Bond Market Signals as Leading Indicators of Bank Fragility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 399-428, March.
  6. Alan D. Morrison & Lucy White, 2005. "Crises and Capital Requirements in Banking," American Economic Review, American Economic Association, vol. 95(5), pages 1548-1572, December.
  7. Morrison, Alan & White, Lucy, 2004. "Crises and Capital Requirements in Banking," CEPR Discussion Papers 4364, C.E.P.R. Discussion Papers.
  8. Ying Liu & Eli Papakirykos & Mingwei Yuan, 2004. "Market Valuation and Risk Assessment of Canadian Banks," Working Papers 04-34, Bank of Canada.
  9. Marc Quintyn & David S. Hoelscher, 2003. "Managing Systemic Banking Crises," IMF Occasional Papers 224, International Monetary Fund.
  10. 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.
  11. Jorge A. Chan-Lau, 2006. "Market-Based Estimation of Default Probabilities and its Application to Financial Market Surveillance," IMF Working Papers 06/104, International Monetary Fund.
  12. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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Citations

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Cited by:
  1. Koutsomanoli-Filippaki, Anastasia I. & Mamatzakis, Emmanuel C., 2011. "Efficiency under quantile regression: What is the relationship with risk in the EU banking industry?," Review of Financial Economics, Elsevier, vol. 20(2), pages 84-95, May.
  2. Winsen, Joseph K., 2010. "An overview of project finance binomial loan valuation," Review of Financial Economics, Elsevier, vol. 19(2), pages 84-89, April.
  3. Martin Saldías Zambrana, 2010. "Systemic risk analysis using forward-looking distance-to-default series," Working Paper 1005, Federal Reserve Bank of Cleveland.
  4. Martin CIHAK, 2007. "Systemic Loss: A Measure of Financial Stability (in English)," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 57(1-2), pages 5-26, March.
  5. Kimie Harada & Takatoshi Ito, 2008. "Did Mergers Help Japanese Mega-Banks Avoid Failure? Analysis of the Distance to Default of Banks," NBER Working Papers 14518, National Bureau of Economic Research, Inc.
  6. Andre Santos & Jorge A. Chan-Lau, 2006. "Currency Mismatches and Corporate Default Risk," IMF Working Papers 06/269, International Monetary Fund.
  7. David E Allen & Akhmad R. Kramadibrata & R. J. Powell & Abhay Kumar Singh, 2011. "Tail Risk for Australian Emerging Market Entities," Working papers 2011-07, Edith Cowan University, School of Business.
  8. Kimie Harada & Takatoshi Ito & Shuhei Takahashi, 2010. "Is the Distance to Default a Good Measure in Predicting Bank Failures? Case Studies," NBER Working Papers 16182, National Bureau of Economic Research, Inc.

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