Equity and Bond Market Signals as Leading Indicators of Bank Fragility

Abstract

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How Accurately Can Z‐score Predict Bank Failure?

“…In addition to the examination of the predictability of Z-scores to bank failure, we also examine to what extent Z-score, the accounting measure of bank distance-todefault, is consistent with the market price based Merton distance-to-default (DD), which is based on Merton's (1974) bond pricing model. Studies have demonstrated the ability of DD measures to predict default risk (Elton et al, 2001;Gropp et al, 2002;Vassalou and Xing, 2004). Kato and Hagendorff (2010) analyze the extent to which distance to default based on market data can be explained using accounting-based indicators of risk for a sample of U.S. bank holding companies.…”

A test for the too-big-to-fail hypothesis for European banks during the financial crisis

“…Although the link between bank size and the safety net policy appears to be more complex than is generally believed (cf. Hetzel, 2009;De Nicolò et al, 2010;Ioannidou and Penas, 2010;Molyneux et al, 2011;Beltratti and Stulz, 2012;Brewer and Jagtiani, 2013), the literature is in near agreement that government bailout guarantees affect the risk exposure of banks by reducing their market discipline, which in turn tempts banks towards an increase in risk-taking and morally hazardous behaviour (Sironi, 2003;Gropp et al, 2006;Völz and Wedow, 2011). 2 Consistency with this evidence, Gropp et al (2011Gropp et al ( , 2014 and Hakenes and Schnabel (2010) show that, in addition to the substantial increases in the risk-taking of banks, bailout policies also induce distortions in competition.…”

Did the Market Signal Impending Problems at Northern Rock? An Analysis of Four Financial Instruments

“…A small literature has examined which market instruments may provide better predictive qualities of bank failure. Three studies have compared the predictive qualities of SND yield spreads and equity-based market indicators, such as DD (Persson and Blåvarg, 2003;Krainer and Lopez, 2004;Gropp et al, 2006). All found that equity market indicators provide more value far from default, whereas yield spreads have a tendency to react close to default.…”

“…This includes, amongst other things, using forward-looking market prices to identify those credit institutions that are most at risk of failure. An extensive literature has empirically analysed the risk sensitivity of subordinated debt (SND) yields and equity prices (Flannery and Sorescu, 1996;Flannery, 1998;Sironi, 2003) and, to a lesser, degree the competing ability of different instruments to identify problem banks (Gropp et al, 2006;Evanoff and Wall, 2001b). In addition, some banking supervisory authorities are showing an increasing interest in the use and quality of market signals on bank condition to support more traditional monitoring mechanisms (European Central Bank (ECB), 2004(ECB), , 2005Schmidt, 2004;Persson and Blåvarg, 2003).…”