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E U R O P E A N C E N T R A L B A N K
WO R K I N G PA P E R S E R I E
E U R O P E A N C E N T R A L B A N K
WO R K I N G PA P E R S E R I E S
AbstractWe 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 codes: G21, G12
Non-technical summaryThis paper examines whether forward-looking indicators of bank soundness could be constructed using financial market data on the securities issued by banks. There is considerable interest on the issue, since market data are available on a high frequency, compared with profit and loss accounts and balance sheets. So far, all empirical evidence has focused on banks' subordinated bond spreads. In this paper, we also examine the properties of an equity market-based indicator, the distance-to-default, and compare its properties to those of the spread. The main contributions of the paper are (i) a theoretical examination of the predictive properties of the two indicators, (ii) the estimation of a proportional hazard model to test these properties, making efficient use of the information contained in the prevalence of an indicator over time, and (iii) an explicit test for the role of the public safety net in the information content of market indicators.Using a standard option pricing framework, we show that the equity-based distance-todefault and the subordinated bond spread have two highly desirable properties to be leading indicators of bank fragility. They are complete in the sense that they reflect the three major determinants of default risk (earnings expectations, leverage and asset risk) and unbiased in the sense that they reflect these risks correctly. However, the theory also suggests that the two indictors exhibit important differences in their predictive ability. In particular, we show that the response of the spreads to...