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An Early Warning Model for EU banks with Detection of the Adverse Selection Effect

  • Olivier BROSSARD (LEREPS-GRES )
  • Frédéric DUCROZET (PSE - Crédit Agricole)
  • Adrian ROCHE (EconomiX - Crédit Agricole)

We estimate an early warning model of banks’ failure using a panel of 82 EU banks observed between 1991 and 2005. We make two contributions to the literature. Firstly, we construct a distance-to-default indicator and test its predictive power. The tests implemented here are very similar to those realized by Gropp, Vesala and Vulpes (2005), but our time dimension is four years longer and we use a more restrictive definition of banks’ “failure”. This first part of the paper establishes the accuracy of our data and confirms the robustness of distance-to-default as an early indicator of EU banks’ fragility. Our second advance consists in introducing a variable detecting the adverse selection problem that can be caused by rapid growth strategies. A measure of past average growth of assets is shown to be a very significant and powerful predictor of future banks’ difficulties. We discuss the origins and implications of such an effect.

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File URL: http://cahiersdugres.u-bordeaux4.fr/2007/2007-08.pdf
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Paper provided by Groupement de Recherches Economiques et Sociales in its series Cahiers du GRES (2002-2009) with number 2007-08.

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Date of creation: 2007
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Handle: RePEc:grs:wpegrs:2007-08
Contact details of provider: Web page: http://gres.u-bordeaux4.fr/
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  1. Isabelle Distinguin & Philippe Rous & Amine Tarazi, 2006. "Market Discipline and the Use of Stock Market Data to Predict Bank Financial Distress," Journal of Financial Services Research, Springer, vol. 30(2), pages 151-176, October.
  2. Rebel Cole & Jeffery Gunther, 1998. "Predicting Bank Failures: A Comparison of On- and Off-Site Monitoring Systems," Journal of Financial Services Research, Springer, vol. 13(2), pages 103-117, April.
  3. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2002. "Equity and bond market signals as leading indicators of bank fragility," Working Paper Series 0150, European Central Bank.
  4. Mark Flannery, 2001. "The Faces of “Market Discipline”," Journal of Financial Services Research, Springer, vol. 20(2), pages 107-119, October.
  5. Edward I. Altman, 1968. "Financial Ratios, Discriminant Analysis And The Prediction Of Corporate Bankruptcy," Journal of Finance, American Finance Association, vol. 23(4), pages 589-609, 09.
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