Is the Distance to Default a good measure in predicting bank failures? A case study of Japanese major banks

Abstract

This paper examines the movements of the Distance to Default (DD), a market-based measure of corporate default risk, of major failed Japanese banks in order to evaluate the predictive power of the DD measure for bank failures. The DD became smaller in anticipation of failure for most cases. Both the DD and DD spread, defined as the DD of a failed bank minus the DD of sound banks, were better indicators for deterioration of a failed bank's health than other traditional indicators. A probit model yielded that the quality of the DD was surely better than other measures. For a bank which window-dressed its financial statements, neither the DD nor the DD spread predicted the failure. However, the result was partly due to lack of transparency in financial statements and disclosed information.