No abstract

Using 20 years of panel data, I demonstrate that high-risk banks have consistently paid more than safe banks for interbank loans and have been less likely to use these loans as a source of liquidity. The economic importance of this effect was relatively small until the mid-1990s, when regulatory and institutional changes began to impose more of the costs of bank failure on uninsured creditors. Subsequently, interbank-market price discipline roughly doubled, and risk-based rationing effects increased by a factor of six. In imposing this discipline, lenders seem to care most about credit risk at borrowing institutions. Copyright (c)2008 The Ohio State University.

We construct daily market-based measures of distance to default for large U.S. financial institutions since 1973. These measures have significant predictive power for institution bankruptcy more than one year in advance. We aggregate the distances to default across institutions to provide an index of the overall health of the financial-services industry. We show that deteriorations in this Financial Institution Health Index are associated with tighter lending standards and higher interest rates on bank loans and precede declines in employment and industrial production. We argue that this points to the condition of financial institutions as an independent source of macroeconomic variability, distinct from traditional accelerator mechanisms.

represent the nature of bank deterioration. Indeed, the few observations that we have of recent bank failures provide evidence consistent with this hypothesis. The changes in the banking environment call for renewed research into the causes of bank distress. The federal supervisory agencies have established research programs pursuing this goal, but-because regulatory banking economists often work on projects with confidential data and because many ongoing projects are not formally disclosed to the public-it can be difficult for outside economists to benefit from this work. By describing some efforts that are currently underway to develop new early-warning models at the Federal Reserve and Federal Deposit Insurance Corporation (FDIC), we attempt to bridge that gap in the hope of stimulating more research in this area beyond that done by government agencies. One strand of the new monitoring devices attempts U nderstanding the causes of insolvency at financial institutions is important for both academic and regulatory reasons, and the effort to model bank deterioration was once a vibrant area of study in empirical finance. Significant advances were made between the late 1960s and late 1980s. Since then, research has slowed considerably on the characteristics of banks headed for trouble, reflecting a sense among researchers that the causes of banking problems are unchanging and well understood. In this article, we argue that this complacency may be unwarranted. 1 The rapid pace of technological and institutional change in the banking sector in recent years suggests that the dominant models may no longer accurately Since 1990, the banking sector has experienced enormous legislative, technological, and financial changes, yet research into the causes of bank distress has slowed. One consequence is that traditional supervisory surveillance models may not capture important risks inherent in the current banking environment. After reviewing the history of these models, the authors provide empirical evidence that the characteristics of failing banks have changed in the past ten years and argue that the time is right for new research that employs new empirical techniques. In particular, dynamic models that use forward-looking variables and address various types of bank risk individually are promising lines of inquiry. Supervisory agencies have begun to move in these directions, and the authors describe several examples of this new generation of early-warning models that are not yet widely known among academic banking economists.