The role of downward assets volatility in assessing the book-value distance to default

Abstract

PurposeThe purpose of this paper is to test the different definitions of “book-value distance to default” (BVDD) to assess whether using downward assets volatility provides some advantage to the index performance or produces adverse impacts on its effectiveness.Design/methodology/approachOur BVDD is a modification of the Merton’s “distance to default” and relies on accounting data only. A survival analysis is conducted by estimating a Cox semiparametric hazard model where the BVDD is built as a function of a parameterθ, which indicates the percentage of upward assets volatility incorporated in its calculation so as to compare its success in predicting banks’ distress over different levels ofθ. The investigation is performed on panel data regarding 866 Italian banks over 21 years.FindingsResults show that while the “pure” downward assets volatility does not catch all the nuances of risk, a small portion of upward deviation allows to notably increase the probability of identifying a distressed bank beforehand.Originality/valueThis study adds to the literature by providing two main contributions. First, it confirms that the BVDD is a reliable measure, being able to predict whether a bank is going to face distress. To the best of the authors’ knowledge, this is the first attempt to appraise BVDD’s accuracy as an index for banks’ soundness through a rigorous econometric experiment. Second, some important insights regarding the Italian banking system may be inferred: larger well-capitalized banks seem to be less likely to fail, whereas credit institutions with higher loans-to-assets ratios are found to be riskier.