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Equity and bond market signals as leading indicators of bank fragility

  • Gropp, Reint
  • Vesala, Jukka
  • Vulpes, Giuseppe

We analyse the ability of the distance-to-default and bond spreads to signal bank fragility. We show that both indicators are complete and unbiased and that spreads are non-linear in the probability of bank default. We empirically test these properties in a sample of EU banks. We find leading properties for both indicators. The distance-to-default exhibits lead times of 6 to 18 months. Spreads have signal value close to default only, in line with the theory. We also find that implicit safety nets weaken the predictive power of spreads. Further, the results suggest complementarity between both indicators, reducing type I errors. We also examine the interaction of the indicators with other bank information. JEL Classification: G21, G12

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Paper provided by European Central Bank in its series Working Paper Series with number 0150.

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Date of creation: Jun 2002
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Handle: RePEc:ecb:ecbwps:20020150
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