Introducing Liquidity Risk in the Contingent-Claim Analysis for the Banks

Traditional approaches to assess the default risk of a bank fail to recognize their basic operations, granting loans and receiving deposits from the public. The contingent claims approach (CCA) is an extension of the Black-Scholes (1973) and Merton (1974) models that calculate the credit risk of a company by characterizing the company’s equity as a call option on its assets. Although a bank can be understood as a firm, anks receive deposits and unlike a common debt, these have to be renewed before the maturity of the assets. This paper proposes a new approach to measure the default risk of a bank based on the CCA, but it includes a stochastic distress barrier in order to capture the funding volatility of the bank. This new framework provides a method to calculate the implied volatility the bank’s assets and their corresponding distance to distress (DD) and the correlation between assets and deposits returns. This methodology is applied to the Chilean banking system in the period of 2003-2012. The results show that there was an important decrease of the DD that coincides with the increment in the funding volatility during the recent crisis.