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Distance-to-Default in Banking: A Bridge Too Far?

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  • Mr. Amadou N Sy
  • Mr. 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.

Suggested Citation

  • Mr. Amadou N Sy & Mr. Jorge A Chan-Lau, 2006. "Distance-to-Default in Banking: A Bridge Too Far?," IMF Working Papers 2006/215, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2006/215
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    References listed on IDEAS

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    Cited by:

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    2. Sinha, Pankaj & Sharma, Sakshi & Sondhi, Kriti, 2013. "Market Valuation and Risk Assessment of Indian Banks using Black -Scholes -Merton Model," MPRA Paper 47442, University Library of Munich, Germany.
    3. Anastasia I. Koutsomanoli‐Filippaki & Emmanuel C. Mamatzakis, 2011. "Efficiency under quantile regression: What is the relationship with risk in the EU banking industry?," Review of Financial Economics, John Wiley & Sons, vol. 20(2), pages 84-95, May.
    4. D. E. Allen & M. McAleer & R. J. Powell & A. K. Singh, 2016. "A capital adequacy buffer model," Applied Economics Letters, Taylor & Francis Journals, vol. 23(3), pages 175-179, February.
    5. Abinzano, Isabel & Corredor, Pilar & Mansilla-Fernández, José Manuel, 2022. "Sovereign debt holdings and banks’ credit risk: Evidence from the Eurozone," Finance Research Letters, Elsevier, vol. 47(PA).
    6. 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.
    7. Fricke, Daniel, 2010. "Contagion between European and US banks: Evidence from equity prices," Kiel Working Papers 1667, Kiel Institute for the World Economy (IfW Kiel).
    8. Saldías, Martín, 2013. "Systemic risk analysis using forward-looking Distance-to-Default series," Journal of Financial Stability, Elsevier, vol. 9(4), pages 498-517.
    9. 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.
    10. Winsen, Joseph K., 2010. "An overview of project finance binomial loan valuation," Review of Financial Economics, Elsevier, vol. 19(2), pages 84-89, April.
    11. Kim Ristolainen, 2016. "The relationship between distance-to-default and CDS spreads as measures of default risk for European banks," Journal of Banking and Financial Economics, University of Warsaw, Faculty of Management, vol. 1(5), pages 121-143, June.
    12. Andrene Senior & Sherene A. Bailey, 2017. "Estimación y pronóstico del riesgo de incumplimiento: evidencias para Jamaica," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 141-174, enero-jun.
    13. Saldías, Martín, 2013. "Systemic risk analysis using forward-looking Distance-to-Default series," Journal of Financial Stability, Elsevier, vol. 9(4), pages 498-517.
    14. Mr. Andre O Santos & Mr. Jorge A Chan-Lau, 2006. "Currency Mismatches and Corporate Default Risk: Modeling, Measurement, and Surveillance Applications," IMF Working Papers 2006/269, International Monetary Fund.
    15. Giovanni Calice & Christos Ioannidis & Julian Williams, 2012. "Credit Derivatives and the Default Risk of Large Complex Financial Institutions," Journal of Financial Services Research, Springer;Western Finance Association, vol. 42(1), pages 85-107, October.
    16. Harada, Kimie & Ito, Takatoshi, 2011. "Did mergers help Japanese mega-banks avoid failure? Analysis of the distance to default of banks," Journal of the Japanese and International Economies, Elsevier, vol. 25(1), pages 1-22, March.
    17. Chan, Stephanie & Wijnbergen, Sweder, 2017. "CoCo Design, Risk Shifting Incentives and Financial Fragility," ECMI Papers 12166, Centre for European Policy Studies.
    18. Jung, Alexander & Uhlig, Harald, 2019. "Monetary policy shocks and the health of banks," Working Paper Series 2303, European Central Bank.
    19. Ignacio Tirado, 2017. "Banking Crises and the Japanese Legal Framework," IMES Discussion Paper Series 17-E-02, Institute for Monetary and Economic Studies, Bank of Japan.
    20. R.J. Powell, 2017. "New perspectives on bank risk in Malaysia," Cogent Economics & Finance, Taylor & Francis Journals, vol. 5(1), pages 1326217-132, January.
    21. Lukasz Prorokowski, 2016. "Bankrupt UK cities: PD model for credit risk in sub-sovereign sector," Bank i Kredyt, Narodowy Bank Polski, vol. 47(6), pages 495-528.
    22. Andrene Senior & Sherene A. Bailey, 2017. "Estimating and Forecasting Default Risk: Evidence from Jamaica," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 133-162, January-J.

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