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Market Indicators, Bank Fragility, and Indirect Market Discipline

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Author Info

  • Reint Gropp

    (European Central Bank)

  • Vesala Jukka

    (European Central Bank)

  • Giuseppe Vulpes

    (UniCredit Banca d'Impresa)

Abstract

We 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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File URL: http://128.118.178.162/eps/fin/papers/0411/0411015.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0411015.

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Length: 10 pages
Date of creation: 10 Nov 2004
Date of revision:
Handle: RePEc:wpa:wuwpfi:0411015

Note: Type of Document - pdf; pages: 10
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Web page: http://128.118.178.162

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Keywords: Banking; Bank fragility; Market indicators; Market discipline; Bankruptcy predictors;

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References

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  1. Yaacov Z. Bergman & Bruce D. Grundy & Zvi Wiener, . "General Properties of Option Prices (Revision of 11-95) (Reprint 058)," Rodney L. White Center for Financial Research Working Papers 1-96, Wharton School Rodney L. White Center for Financial Research.
  2. Douglas Evanoff & Larry Wall, 2001. "Sub-debt Yield Spreads as Bank Risk Measures," Journal of Financial Services Research, Springer, vol. 20(2), pages 121-145, October.
  3. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  4. Hand, John R M & Holthausen, Robert W & Leftwich, Richard W, 1992. " The Effect of Bond Rating Agency Announcements on Bond and Stock Prices," Journal of Finance, American Finance Association, vol. 47(2), pages 733-52, June.
  5. Diana Hancock & Myron Kwast, 2001. "Using Subordinated Debt to Monitor Bank Holding Companies: Is it Feasible?," Journal of Financial Services Research, Springer, vol. 20(2), pages 147-187, October.
  6. anonymous, 1999. "Using subordinated debt as an instrument of market discipline," Staff Studies 172, Board of Governors of the Federal Reserve System (U.S.).
  7. 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.
  8. Diana Hancock & Myron L. Kwast, 2001. "Using subordinated debt to monitor bank holding companies: is it feasible?," Finance and Economics Discussion Series 2001-22, Board of Governors of the Federal Reserve System (U.S.).
  9. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2002. "Equity and bond market signals as leading indicators of bank fragility," Working Paper Series 0150, European Central Bank.
  10. 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, vol. 26(5), pages 1011-1028, May.
  11. Bergman, Yaacov Z & Grundy, Bruce D & Wiener, Zvi, 1996. " General Properties of Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1573-1610, December.
  12. Robert R. Bliss, 2000. "The pitfalls in inferring risk from financial market data," Working Paper Series WP-00-24, Federal Reserve Bank of Chicago.
  13. Gropp, Reint & Richards, Anthony J., 2001. "Rating agency actions and the pricing of debt and equity of European banks: What can we infer about private sector monitoring of bank soundness?," Working Paper Series 0076, European Central Bank.
  14. Flannery, Mark J, 1998. "Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(3), pages 273-305, August.
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