Market Indicators, Bank Fragility, and Indirect Market Discipline
AbstractWe examine whether two commonly used indicators of bank fragility, the subordinated debt spread and KMV’s distance to default, yield signals in line with supervisors’ interests. We argue that supervisors would prefer indicators that are strictly increasing in earnings, and decreasing in leverage and earnings volatility. Using standard option pricing, we show that the two indicators do indeed satisfy these properties if the firm is still solvent. We also summarise the results from a test of these properties in a sample of EU banks during the 1990s. The results suggest that the distance to default signals bank fragility earlier than the subordinated debt spread. Also, the spread is affected by the implicit safety net of the bank. Finally, the results suggest that the indicators may add marginal value to accounting information through a reduction in Type II (“false positive”) errors.
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Bibliographic InfoPaper provided by EconWPA in its series Finance with number 0411015.
Length: 10 pages
Date of creation: 10 Nov 2004
Date of revision:
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Banking; Bank fragility; Market indicators; Market discipline; Bankruptcy predictors;
Other versions of this item:
- Reint Gropp & Jukka Vesala & Giuseppe Vulpes, 2004. "Market indicators, bank fragility, and indirect market discipline," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 53-62.
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- C35 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Discrete Regression and Qualitative Choice Models; Discrete Regressors; Proportions
- C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis; Optimal Timing Strategies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-11-22 (All new papers)
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