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Using extreme value theory to estimate the likelihood of banking sector failure

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  • Hans Bystrom

Abstract

The growing interest in management of credit risk and estimation of default probabilities has given rise to a range of more or less elaborate credit risk models. While these models work well for non-financial firms they are usually not very successful in capturing the financial strength of banks. As an answer to this, Hall and Miles suggest a simple approach of estimating bank failure probabilities based solely on their stock prices. This paper suggests an extension to the Hall and Miles model using extreme value theory and applies the extended model to the Swedish banking sector around the banking crisis of the early 1990s. The extended model captures very well the increased likelihood of a systemic banking sector failure around the peak of the crisis and it produces default probabilities that are more stable, more realistic and more consistent with Moody's and Fitch rating implied default rates than probabilities from the original Hall and Miles model.

Suggested Citation

  • Hans Bystrom, 2006. "Using extreme value theory to estimate the likelihood of banking sector failure," The European Journal of Finance, Taylor & Francis Journals, vol. 12(4), pages 303-312.
  • Handle: RePEc:taf:eurjfi:v:12:y:2006:i:4:p:303-312
    DOI: 10.1080/13518470500146116
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    References listed on IDEAS

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    1. Berger, Allen N & Davies, Sally M & Flannery, Mark J, 2000. "Comparing Market and Supervisory Assessments of Bank Performance: Who Knows What When?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 641-667, August.
    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    3. 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 637-654, May-June.
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    Cited by:

    1. Marco Rocco, 2011. "Extreme value theory for finance: a survey," Questioni di Economia e Finanza (Occasional Papers) 99, Bank of Italy, Economic Research and International Relations Area.

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