Equity and bond market signals as leading indicators of bank fragility

We analyse the ability of equity market-based distances-to-default and subordinated bond spreads to signal a material weakening in banks' financial condition. Using option pricing, we show that both indicators are complete and unbiased indicators of bank fragility. We empirically test these properties using a sample of EU banks. Two different econometric models are estimated: a series of logit-models, which were estimated for different time-leads, and a proportional hazard model. We find support in favour of using both the distance-to-default and spread as leading indicators of bank fragility, regardless of our econometric specification. However, while we find robust predictive performance of the distance-to-default between 6 to 18 months in advance, its predictive properties are quite poor closer to the default. In contrast, subordinated debt spreads seem to have signal value close to default only. We also find that the predictive power of spreads appears to be weakened by implicit safety nets. We find no such evidence for the distances-to-default. Further, we find support for the notion that the market-based predictors of default have predictive power even controlling for balance sheet information and that both indicators may complement each other. We interpret our finding as providing some measure of support for the use of market information in supervisor's early warning models.