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Distance-To-Default in Banking; A Bridge too Far?

  • Amadou N. R. Sy
  • Jorge A. Chan-Lau

In contrast to corporate defaults, regulators typically take a number of statutory actions to avoid the large fiscal costs associated with bank defaults. The distance-to-default, a widely used market-based measure of corporate default risk, ignores such regulatory actions. To overcome this limitation, this paper introduces the concept of distance-to-capital that accounts for pre-default regulatory actions such as those in a prompt-corrective-actions framework. We show that both risk measures can be analyzed using the same theoretical framework but differ depending on the level of capital adequacy thresholds and asset volatility. We also use the framework to illustrate pre-default regulatory actions in Japan in 2001-03.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/215.

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Length: 17
Date of creation: 01 Sep 2006
Date of revision:
Handle: RePEc:imf:imfwpa:06/215
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  1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Jorge A. Chan-Lau, 2006. "Market-Based Estimation of Default Probabilities and its Application to Financial Market Surveillance," IMF Working Papers 06/104, International Monetary Fund.
  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 637-54, May-June.
  4. Marc Quintyn & David S. Hoelscher, 2003. "Managing Systemic Banking Crises," IMF Occasional Papers 224, International Monetary Fund.
  5. Morrison, Alan & White, Lucy, 2004. "Crises and Capital Requirements in Banking," CEPR Discussion Papers 4364, C.E.P.R. Discussion Papers.
  6. Raj Aggarwal & Kevin T. Jacques, 1998. "Assessing the impact of prompt corrective action on bank capital and risk," Economic Policy Review, Federal Reserve Bank of New York, issue Oct, pages 23-32.
  7. María J. Nieto & Larry D. Wall, 2007. "Preconditions for a successful implementation of supervisors' Prompt Corrective Action: Is there a case for a banking standard in the EU?," Banco de Espa�a Working Papers 0702, Banco de Espa�a.
  8. Reint Gropp & Jukka Vesala & Giuseppe Vulpes, 2002. "Equity and bond market signals as leading indicators of bank fragility," Conference Series ; [Proceedings], Federal Reserve Bank of Boston.
  9. Ying Liu & Eli Papakirykos & Mingwei Yuan, 2004. "Market Valuation and Risk Assessment of Canadian Banks," Working Papers 04-34, Bank of Canada.
  10. Martin Cihák, 2006. "How Do Central Banks Writeon Financial Stability?," IMF Working Papers 06/163, International Monetary Fund.
  11. Alan D. Morrison & Lucy White, 2005. "Crises and Capital Requirements in Banking," American Economic Review, American Economic Association, vol. 95(5), pages 1548-1572, December.
  12. Arnaud Jobert & Janet Kong & Jorge A. Chan-Lau, 2004. "An Option-Based Approach to Bank Vulnerabilities in Emerging Markets," IMF Working Papers 04/33, International Monetary Fund.
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