Bank Financial Distress Research Articles

Credit Default Swaps as Indicators of Bank Financial Distress

We examine whether CDS contracts written on individual banks are effective leading indicators of bank financial distress. Changes in CDS spreads are found to represent a robust signal of bank failure, in keeping with indirect market discipline. Furthermore, changes in CDS spreads provide information about the condition of banks which supplements that available from equity markets and contained in accounting metrics. Consistent results are detailed for both senior and subordinated CDS spreads. Our results hold out-of-sample, for various cohorts, for idiosyncratic changes in CDS, for an alternative estimation method and are robust to the use of alternative measures of bank distress, including rating downgrades and accounting risk.

Economic value, competition and financial distress in the European banking system

In this paper we examine the impact of a large number of factors at the bank level (liquidity and credit risks, asset size, income diversification and market power), at the industry level (banking concentration) and macro-level (real GDP growth) on bank financial distress using an unbalanced panel of 308 European commercial banks between 1996 and 2009. The observations falling below a given threshold of the empirical distribution of the Shareholder Value Ratio proxy bank financial distress. We employ a panel probit regression and, given the presence of overlapping data giving rise to residual autocorrelation, we use the Bertschek and Lechner (1998) robust estimator of the covariance matrix of parameters. We show that credit risk, liquidity risk and bank market power are the most influential determinants of distressed Shareholder Value Ratio. Finally we evaluate the model out-sample forecasting performance over the 2008–2009 crisis period.

Prudential, Pragmatic, and Prescient, Reform of Bank Resolution Schemes

AbstractThis article examines current initiatives in respect of bank financial distress in response to the 2008‐2009 financial crisis, suggesting that there is considerably more work to be undertaken before bank regulatory oversight, bank corporate governance, and bank resolution regimes have the appropriate preventive safeguards, governance, and timely, efficient and fair responses to bank financial distress. The corporate governance of banks and other financial institutions differs from the governance of corporations because of prudential regulation, banks' significance to the financial system, the different nature of stakeholders with investments at risk, and the existence of deposit insurance. The article offers a number of policy options in respect of how banks and other financial institutions could enhance their prudential, prescient, and pragmatic oversight and governance in a way that protects creditors, deposit holders, and other stakeholders, as well as the public interest in a healthy and sustainable financial sector. Copyright © 2012 John Wiley & Sons, Ltd.

Bank failure prediction models: for the developing and developed countries

Banks make good use of capital and have characteristics different from profit businesses. Mismanagement causes collapse, which negatively affects investors, depositors, and employees, and disrupts economic order. Consequences may also affect other industries, triggering financial distress. Therefore, evaluating operational risks in banks and developing an early warning system are critical. This study evaluates data from 858 international banks (including banking holding companies) from 2005 to 2008 and applies a logistic model to analyze critical factors. Results show that equity-to-assets (ETA) and interest income – interest expense/income (NIN) had negative relationships with financial distress. Banks accept deposits and make loans. A higher proportion of NIN shows stable business volume, which could avert financial distress. Therefore, ETA and NIN were indicative of banking financial distress and best predicted trends in Association of Southeast Asian Nations (ASEAN) and European Union (EU) banks.

The Impact of Bank Concentration on Financial Distress: The Case of the European Banking System

This paper examines the impact of bank concentrationon bank financial distress using a balanced panel of commercial banks in the EU‐25 over a sample period running from 2003 to 2007. Financial distress is proxied by the observations falling below a given threshold of the empirical distribution of a risk‐adjusted indicator of bank performance: the Shareholder Value Ratio. We employ a panel probit regression estimated by GMM in order to obtain consistent and efficient estimates, following the suggestion made by Bertschek and Lechner (1998). After controlling for a number of environment variables, we conclude that our findings suggest a positive effect of bank concentration on financial distress.

The use of accounting data to predict bank financial distress in MENA countries

Using an innovative approach of following the downgrade or credit rating decisions by rating agencies, this paper develops an early-warning system of bank financial distress and critically evaluates the reliability and stability of the potential indicators or factors of banks in 13 emerging economies in the MENA region. Evidence portrays that the capital, asset quality, earnings, and liquidity ratios are accurate accounting indicators to predict bank financial distress. However, we observe that influence of factors vary across size of the banks as accounting information does not appear reliable to predict bank financial distress of small banks. By contrast, the balance sheet structure of banks (both the asset side and liability side) does not affect the accuracy of accounting indicators.

Cross-Border Banking and the International Transmission of Financial Distress During the Crisis of 2007-2008

We study the effect of financial distress in foreign parent banks on local SME financing in 14 central and eastern European countries during the early stages of the 2007-2008 financial crisis. We use survey data on applicant and non-applicant firms that enable us to disentangle effects driven by shocks to the banking system from recession-driven demand shocks that may vary across lenders. We find strong evidence that credit tightened in the relatively early stages of the crises caused by the following types of bank financial distress: 1) low equity ratio; 2) low Tier 1 capital ratio; and 3) losses on financial assets. We also find that foreign banks transmit to Main Street a larger portion of similar financial shocks than domestic banks. The observed decline in credit is greater among high-risk firms and firms with fewer tangible assets.

The Impact of Bank Concentration on Financial Distress: The Case of the European Banking System

This paper examines the impact of bank concentration on bank financial distress using a balanced panel of commercial banks belonging to EU 25 over the sample period running from 2003 to 2007. Financial distress is proxied by the observations falling below a given threshold of the empirical distribution of a risk adjusted indicator of bank performance: the Shareholder Value ratio. We employ a panel probit regression estimated by GMM in order to obtain consistent and efficient estimates following the suggestion of Bertschek and Lechner (1998). Our findings suggest, after controlling for a number of enviroment variables, a positive effect of bank concentration on financial distress.

The Use of Accounting and Stock Market Data to Predict Bank Financial Distress: The Case of East Asian Banks

This paper investigates whether market information could add to accounting information in the prediction of bank financial distress in Asia. A stepwise logit model is first estimated to isolate the optimal set of accounting indicators and then extended to include market indicators. Dummy variables are also introduced in the model to account for the possible existence of a too-big-to-fail effect. While some results show that market indicators bring in additional information in the prediction process, there is consistent evidence of a too-big-to-fail effect.

Market Discipline and the Use of Stock Market Data to Predict Bank Financial Distress

We assess the extent to which stock market information can be used to estimate leading indicators of bank financial distress. We specify a logit early warning model, designed for European banks, which tests if market based indicators add predictive value to models relying on accounting data. We also study the robustness of the link between market information and financial downgrading in the light of the safety net and asymmetric information hypotheses. Some of our results support the use of market-related indicators. Other results show that the accuracy of the predictive power depends on the extent to which bank liabilities are market traded.

Contrôle prudentiel et détection des difficultés financières des banques

L'objectif de cet article est d'etudier le role que peut jouer, pour les autorites prudentielles, le marche des actions dans la detection avancee des degradations financieres des banques. On teste, dans le cas europeen, l'apport d'indicateurs construits a partir du cours des actions, en complement des indicateurs comptables habituellement utilises et la pertinence de cet apport pour des etablissements par nature opaques. Les resultats concluent a l'apport significatif des indicateurs de marche. Ils montrent cependant qu'il est difficile d'en extraire de l'information pour les banques a forte collecte de depots, quel que soit le montant des titres subordonnes emis.

Market Discipline and the Use of Stock Market Data to Predict Bank Financial Distress

We assess the extent to which stock market information can be used to estimate leading indicators of bank financial distress. We specify a logit early warning model, designed for European banks, which tests if market based indicators add predictive value to models relying on accounting data. We also study the robustness of the link between market information and financial downgrading in the light of the safety net and asymmetric information hypotheses. Some of our results support the use of market-related indicators. Other results show that the accuracy of the predictive power depends on the extent to which bank liabilities are market traded.

Regulator Use of Market Data to Improve the Identification of Bank Financial Distress

This paper assesses the extent to which stock market information may help bank regulators identify bank financial distress. The research specifies a variety of stock return and other market-related variables that might contain elements of longer-term trends and be capable of anticipating changes in regulatory ratings of commercial banks and thrift institutions. Univariate tests confirm a remarkable tendency for market-related variables to decline, or otherwise move, far in advance of formal regulatory rating downgrades, a finding suggesting that these variables may have useful predictive content. Furthermore, multivariate tests support the notion that market-related variables add predictive value to the value contained in publicly available Call Report financial data. The evidence supports the use of market-related variables in off-site monitoring applications.

Credit derivatives in banking: Useful tools for managing risk?

We model the effects on banks of the introduction of a market for credit derivatives; in particular, credit-default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the “lemons” problem caused by banks’ superior information about the credit quality of their loans. However, we find that the introduction of a credit-derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down.

The effects of the Norwegian banking crisis on Norwegian equities

We examine the information effects of Norwegian savings and commercial bank financial distress announcements on Norwegian bank and non-bank stock prices. We find that Norwegian commercial bank failures during the Norwegian banking crisis were associated with negative common stock abnormal returns for both Norwegian banks and large Norwegian corporations listed on the Oslo Børs. We interpret this finding as supporting the conclusion of Norges Bank that the banking crisis was an economy-wide systemic crisis and required intervention by Norges Bank and the Norwegian government. Although we find no systemic market-wide information effects associated with the failure of Norwegian savings banks, we are reluctant to conclude that these bank failures had no effect on the households, businesses and local economies served by these banks. The absence of negative abnormal returns on large commercial banks or publicly listed Norwegian corporations for the savings-bank events may reflect the fact that large commercial banks were serving a different banking clientele than the savings banks and that large Norwegian corporations did not rely on savings banks for financing.

Credit Derivatives in Banking: Useful Tools for Managing Risk?

We model the effects on banks of the introduction of a market for credit derivatives--in particular, credit default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans would trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the "lemons" problem caused by banks' superior information about the credit quality of their loans. However, we find that the introduction of a credit derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down. In this case, the existence of a credit derivatives market will lead to a greater risk of bank insolvency.