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Distance to default, subordinated debt, and distress indicators in the banking industry

Authors


  •  Winner of the Best Paper Prize at the 7th International Conference on Financial Markets, Good Governance, and Economic Development (2008) in Dar es Salaam, Tanzania. We thank Robert Faff (the editor), David Hillier, Allan Hodgson, Iain Clacher, Joshua Doriye, Francesco Vallascas, as well as the participants at the Institute of Finance Management in Tanzania for valuable comments. All remaining errors are our own.

Abstract

The recent financial crisis has highlighted the inadequacy of present supervisory arrangements to identify reliable ex-ante indicators of banking distress. For a sample of US bank holding companies, we analyse the extent to which distance to default based on market data can be explained using accounting-based indicators of risk. We show that a larger number of bank fundamentals help predict default for institutions that issue subordinated debt. For banks that issue sub-debt, we find that higher charter values and low bank capitalizations further increase the power of bank fundamentals to predict default risk.

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