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Distance-to-default measures and determinants for systemically important financial institutions

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  • Natalya A. Schenck

Abstract

Purpose - – This study aims to compare two distance-to-default methods, data-transformed maximum likelihood estimation and “naïve”, that are suitable for financial institutions. The links between these measures and asset size, Tier 1 and Tier 2 capital ratios, non-performing assets and operating efficiency have been examined and an alternative default risk measure has been introduced. Most of the market-based distance-to-default measures are not appropriate for banks due to their unique debt structure. Design/methodology/approach - – The author has compared two distance-to-default measures and has identified their accounting determinants using Pearson’s correlation and regressions with clustered standard errors. The sample of the US-based systemically important financial institutions covers the period from 2000 to 2010. Findings - – Non-performing assets and operating efficiency are found to be statistically and economically significant determinants of both distance-to-default measures. Tier 1 capital ratio is not a significant indicator of default risk. Practical implications - – The results emphasize the importance of using a combination of market-based default risk measures and accounting ratios in default prediction models for the financial institutions. Originality/value - – This paper identifies accounting determinants of two distance-to-default measures for large financial institutions, before and during the 2008 financial crisis. It introduces a spread between two measures as an alternative default risk indicator.

Suggested Citation

  • Natalya A. Schenck, 2014. "Distance-to-default measures and determinants for systemically important financial institutions," Journal of Financial Regulation and Compliance, Emerald Group Publishing, vol. 22(2), pages 159-172, May.
  • Handle: RePEc:eme:jfrcpp:v:22:y:2014:i:2:p:159-172
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    More about this item

    Keywords

    Financial crisis; Banks; Distance-to-default; Default risk; G21; G28; G32;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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