Academic journal article Federal Reserve Bank of New York Economic Policy Review

Market Indicators, Bank Fragility, and Indirect Market Discipline

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Market Indicators, Bank Fragility, and Indirect Market Discipline

Article excerpt

1. INTRODUCTION

From a supervisory perspective, the prices of securities issued by banks are interesting because they may complement or even be a substitute for traditional accounting data in assessing bank fragility. Market prices may efficiently summarise all available information in one convenient indicator. Moreover, market information is available at a very high frequency. Market information is also inherently more forward looking than accounting data. Hence, it has been proposed that supervisors use these signals as screening devices or inputs into early-warning models geared at identifying banks, which should be more closely scrutinised. (1)

This paper aims to ascertain the quality (that is, the predictive power and prediction errors) of two market indicators: the distance to default and the subordinated debt spread. Previous work has established that banks' market prices reflect contemporaneous information about bank risk in the United States and in Europe. (2) In our study, we first examine the theoretical properties of the indicators, namely, whether or not they are aligned with the conservative objectives of supervisors. We propose that in order to be aligned with these objectives, market indicators of bank fragility should be decreasing in earnings expectations, and increasing in earnings volatility and leverage. Using simple option-pricing theory, we show that the subordinated debt spread and the negative distance to default do indeed satisfy these properties. (3) We also find that the signal-to-noise ratio of subordinated debt spreads should be quite low far away from the default point of the bank. We then summarise the results obtained in Gropp, Vesala, and Vulpes (2002), which suggest that both indicators may have some usefulness in predicting bank fragility in the European Union (EU).

Based on two different econometric models--a legit model and a proportional hazard model--our results show that the negative distance to default predicts downgrades between six and eighteen months in advance and that the predictive properties are quite poor the closer to failure. In contrast, the predictive powers of spreads diminish beyond twelve months prior to a downgrade. The analysis also indicates that spreads are useful predictors only for banks, which are not implicitly insured against default, while the public safety net does not appear to affect the predictive power of the distance to default.

Furthermore, our results suggest that the distance to default provides some additional information relative to accounting variables, while this is not so for the spread. We also find support for the notion that the two indicators together have more discriminatory power in predicting failures than each does alone. In particular, "Type II" errors (a sound bank classified as weak) are reduced in a model that includes both market-based indicators. Similarly, market indicators reduce Type II errors relative to a model using accounting data alone. Hence, the use of market indicators may prevent supervisors from chasing false leads.

The remainder of our paper is organised as follows. Section 2 briefly summarises the previous empirical literature. In Section 3, we present our main theoretical results, and in Section 4 we offer a summary of the empirical results obtained in Gropp, Vesala, and Vulpes (2002).

2. PREVIOUS LITERATURE

A number of recent papers studying U.S. banks are closely related to our work. Curry, Elmer, and Fissel (2001) find that stock prices exhibit a downward trend as many as two years before a supervisory CAMEL (Capital adequacy, Asset quality, Management, Earnings, and Liquidity) rating downgrade to 3, 4, or 5. Also, adding market variables to standard equations containing call report financial data improves their predictive power, especially for banks in the greatest financial distress. Evanoff and Wall (2001) find that accounting information has almost no predictive power for CAMEL and BOPEC (Bank subsidiaries, Other nonbank subsidiaries, Parent company, Earnings, and Capital adequacy) supervisory rating downgrades, but subordinated debt spreads perform only slightly better. …

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