Bank Distress Research Articles

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

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.

The real effects of bank distress: Evidence from bank bailouts in Germany

How does bank distress impact their customers' probability of default and trade credit availability? We address this question by looking at a unique sample of German firms from 2000 to 2011. We follow their firm-bank relationships through times of distress and crisis, featuring the different transmission of bank distress shocks into already weakened firm balance sheets. We find that a distressed bank bailout, which is subject to restructuring and deleveraging conditions, leads to a bank-induced increase of firms' probabilities of default. Moreover, bailouts tend to reduce trade credit availability and ultimately firms' sales. We further find that the direction and magnitude of the effects depends on firm quality and the relationship orientation of banks.

Market concentration, diversification, and financial distress in the Indonesian banking system

The economic theory provides conflicting predictions about the relationship between the market structure of the banking industry and financial distress. The view of concentration-fragility argues that a banking structure that is more concentrated with a number of large banks is more vulnerable to financial fragility than a banking sector that is less concentrated with many banks. We examine how the concentration market, market share, and diversification affect the bank's financial distress. Using the purposive sampling method and data of listed banks in the 2014-2017 period, the results of statistical tests with logistic regression showed that market concentration has a positive effect on the bank’s financial distress. The more concentrated the market, the greater the probability of the occurrence of financial distress in Indonesian banks. We also prove the validity of the SCP (The Structure-Conduct-Performance) hypothesis and efficiency hypothesis. Therefore, regulations need to be made in order to reduce this highly concentrated market so that the probability of financial distress decreases. JEL Classification : D4, G2 DOI: https://doi.org/10.26905/jkdp.v23i4.2693

Predicting Distress in Islamic Banks: The Effectiveness of Capital Measures in CAMELS Framework

This study aims to identify key capital adequacy measures and other parameters that effectively predict distress in Islamic banks taking a panel of 65 banks from 13 countries between 2008-2017 using logistic regression model. The paper also intends to see whether simpler ratios perform better than more complex, risk weighted measures in predicting distress in these banks. A total of nine alternative capital and leverage indicators are used in the model that mainly rely on financial and accounting data, which are supplemented by the addition of market leverage for listed banks. In order to capture variability in cross country analysis and impact of economic conditions and shocks, the study also adds several macroeconomic indicators in the model. The results suggest that most of the standard CAMELS indicators are relevant for studying distress in Islamic banks. Further, it is shown that three other capital ratios – Tier 1, tangible common ratio and market leverage - are equally effective in studying Islamic bank failures. The findings, however, reflect that Basel III leverage ratio and other accounting-based ratios do not offer effective early warning signals of Islamic bank stress. Overall, equity based risk-weighted capital ratios offer a more robust framework of regulation and supervision in Islamic banks.

How did regulation and market discipline influence banking distress in Europe?

PurposeThis paper aims to examine the relationship between regulation, market discipline and banking distress.Design/methodology/approachTo address the empirical question put forward above, a multivariate logit model is applied to an international sample of 586 banks from 21 European countries in the period between 2000 and 2012. To give robustness to the results, different variables have been used to test the role played by market discipline and regulation as well as an alternative methodology known as duration/survival analysis.FindingsIt can be found that market discipline is a good indicator in signalling banking distress, that is, market discipline has penalized more banks with a higher likelihood of being in distress. Nonetheless, as broadly acknowledged, market discipline was not sufficient per se to avoid banking distress in Europe. With regard to regulation, this paper evidences that the adoption of other regulatory measures beyond the simple transposition of changes occurred in the EU Directives such as borrower-based measures and limits on pre-emptive exposures’ concentration, have contributed toward reducing the probability of distress of EU banks, showing that the introduction of this kind of measures was necessary and relevant. In addition, in this paper, it can be found that the NPL ratio, size, capital (including the well-known regulatory capital ratio, as well as the novel leverage ratio which discards the risk weights present in the former one) and liquidity are good indicators of banking distress which lead us to conclude that the new regulatory framework known as Basel III is on the right path to mitigate the probability that a new banking crisis similar to the last one takes place again.Research limitations/implicationsThe first limitation regards the period of time chosen, that is, from 2000 to 2012, empirically neglecting, to some extent the important regulatory changes occurred after the aforementioned period. Nonetheless, as mentioned in the Data and Methodology section, the period ends in 2012 because it is difficult to flag a reasonable number of banks’ bailouts afterwards, to properly run the type of model used in this paper. The second limitation is the fact that the possible changes in the risk management and risk assessment by institutions and in the behaviour of investors, acknowledge as weak and inappropriate before the on-set of the global financial crisis, albeit very relevant, are not in the scope of this paper.Practical implicationsDespite the welcomed changes performed by regulators so far, some aspects are not complete yet and new areas deserve more empirical work and attention by the regulators and supervisors. Some of them stem directly from the results obtained from this paper such as the enhancement and a close monitoring of the current Pillar 3 framework the increase of the adoption of more targeted tools, in a more preemptive way, to counter the build-up of risks and the implementation of the leverage ratio.Originality/valueIn the aftermath of the financial crisis, the identification of leading indicators signalling emerging risks to the banking system has become a major priority to central banks and supervisory authorities. As a consequence, several studies have formulated the aim of analysing predictive characteristics of a set of macroeconomic variables, such as GDP Growth, Credit-to-GDP, Inflation, M2-to-GDP, among others. Other studies take a different perspective and complement the analysis with bank-specific risk indicators. Nonetheless the aforementioned studies do not consider the relationship between regulation and market discipline and banking distress. This is the gap the authors wanted to fill, and this assessment is the main contribution of this paper.

Micro-Evidence From a System-Wide Financial Meltdown: The German Crisis of 1931

This paper studies a major financial panic, the run on the German banking system in 1931, to distinguish between banking theories that view depositors as demanders of liquidity and those that view them as providers of discipline. Our empirical approach exploits the fact that the German Crisis of 1931 was system-wide with cross-sectional variation in deposit flows as well as bank distress and took place in absence of a deposit insurance scheme. We find that interbank deposit flows predict subsequent bank distress early on. In contrast, wholesale depositors are more likely to withdraw from distressed banks at later stages of the run and only after the interbank market has started to collapse. Retail deposits are—despite the absence of deposit insurance—largely stable. Our findings emphasize the heterogeneity in depositor roles, with discipline being best provided through the interbank market.

Do bank liquidity shocks hamper firms’ innovation?

This paper highlights the importance of bank-based finance for the innovation activity of UK firms. It identifies both theoretically and empirically how bank shocks affect firms’ innovation. We develop a theoretical model, and test its predictions using a new matched bank-firm-patent dataset for the UK. We find that bank distress during the 2008 and 2011 crises negatively affected firms’ innovation behavior. After carefully controlling for several potential biases in estimation we find that firms whose relationship banks were distressed not only patented less, but those patents were of lower technological value, less original and of lower quality. The negative effect is significantly larger in the case of small and medium size enterprises (SMEs). We also find that banks’ specialization in financing innovation mitigates the impact of bank distress on innovation.

DRIVERS OF AUDIT FAILURE AND FRAUDULENT FINANCIAL REPORTING: EVIDENCE FROM NIGERIAN DISTRESSED BANKS

This study examined the drivers (prime facilitators and the motivations) of fraudulent financial reporting and audit failures in distressed Nigerian distressed banks. The study carried out an analytical review of literature that includes previous empirical studies, reports of investigations of the Nigerian Banks by Financial Regulatory Agencies and content analysis of the audited financial statements of the distressed banks. The major findings of this study are that the Audit failures that featured in the distressed banks were driven by the overwhelming influence of the board over their auditors. The board through the purchase of their ‘desired’ poor audit quality’ at high cost, exposed the auditors to economic bonding which compromised their independence and facilitated the issuance of favourable/unqualified audit opinion on the board’s fraudulent financial statements that covered up the boards unethical management practices and material irregularities that undermined the going concern prospects of the banks. The auditors favourable opinions were proved to be untrue, thus resulting in Audit failures. The policy implications of the inferences from this study is that the Nigerian legal and corporate accounting and auditing framework require the fundamental re-engineering of its rules and structure so as to shield auditors from the undue influence of the boards, checkmate the excesses of the executive directors through the upward review of the proportion of non-executive directors on boards, while also providing adequate control over the periodic upward review of audit fees.

Do Distressed Banks Really Gamble for Resurrection?

We explore the actions of financially distressed banks in two distinct periods that include financial crises (1985-1994, 2005-2014) and differ in bank regulations, especially concerning capital requirements and enforcement. In contrast to the widespread belief that distressed banks gamble for resurrection, we document that distressed banks take actions to reduce leverage and risk, such as reducing asset and loan growth, issuing equity, decreasing dividends, and lowering deposit rates. Despite large differences in regulation between periods, the extent of deleveraging is similar, suggesting that economic forces beyond formal regulations incentivize bank managers to deleverage when their banks are in distress.

Cross-Border Lending, Government Capital Injection, and Bank Performance

In this paper, we develop a contingent claim model to examine the optimal bank interest margin, i.e., the spread between the domestic loan rate and the deposit market rate of an international bank in distress. The framework is used to evaluate the cross-border lending efficiency for a bank that participates in a government capital injection program, a government intervention used in response to the 2008 financial crisis. This paper suggests that government capital injection is an appropriate way to recapitalize the distressed bank, enhancing the bank interest margin and survival probability. Nevertheless, the government capital injection lacks efficiency when the bank’s cross-border lending is high. Stringent capital regulation, suggested to prevent future crises by literature, leads to superior lending efficiency when the government capital injection is low.

Using Annual Report Sentiment as a Proxy for Financial Distress in U.S. Banks

abstractCurrent measures of bank distress find marginal value in predictive variables beyond a capital adequacy ratio and tend to miss extreme events impacting the entire sector. The authors advocate a new proxy for bank distress: sentiment measures from banks’ annual reports. After controlling for popular forecasting variables used in the literature, they find that more negative sentiment in the annual report is associated with larger delisting probabilities, lower odds of paying subsequent dividends, higher subsequent loan loss provisions, and lower future return on assets. The findings suggest that regulators could augment current early warning systems for banks and the banking sector—where the measures are based exclusively on financial statement data—by using the frequency of negative words in banks’ annual reports.

Empirical Evaluation of Current Assets Investment and Corporate Financial Returns in Nigeria

The unceasing apprehension of probable distress of commercial banks in Nigeria has raised concerns on the quality of current assets investment and management in the Nigerian banking industry. Hence, the study analyzed the impact of current assets investment & management on corporate financial returns of listed commercial banks in Nigeria. The longitudinal research design was adopted and secondary data of eight (8) banks whose annual reports were available as at the end of 2016 was randomly selected from the population of fifteen (15) listed deposit money banks in the Nigerian Stock Exchange. Ordinary least square (OLS) regression analysis was employed to determine the association between current assets investment and corporate financial returns. The results of the study indicate that there exist a significant positive relationship between loans and advances granted to customers and return on assets (r =.443, p-value =.004). This leads to the rejection of the null hypothesis, which states that loans and advances granted to customers have no positive influence on return on assets. The relationship between loans and advances granted to other banks and return on assets is negative and significant at 5% confidence level (r = .369, p-value =.019).This leads to the non-rejection of the null hypothesis, which states that loans and advances granted to other banks have no positive impact on returns on assets. The other predictor variables (financial assets held for trading & cash, and cash balances) have an insignificant positive relationships with return on assets. It was therefore recommended that bank managers should not only increase their investment in current assets but they should also consider the most effective and efficient way of managing these assets in order to improve their financial efficiency and corporate value. To this end, the conservative or aggressive current assets investments policy might be pursued depending on the strategic focus of the firm.

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 during a period of systemic bank crisis. Changes in CDS spreads are found to yield a robust signal of failure across a set of European and US banks, 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. Our findings hold out-of-sample, for various cohorts, for subordinated CDS spreads, for idiosyncratic changes in CDS and are robust to the use of alternative measures of bank distress, including rating downgrades and accounting risk.

The Case of Yes Bank: From the Founders’ Dream to a Bank in Distress

The Case of Yes Bank: From the Founders’ Dream to a Bank in Distress

Political connections, government capital injection, and deposit insurance premium

PurposeThe purpose of this paper is to develop a capped barrier option framework to consider the politically preferential treatment for bank loans incentivized by government capital injections and calculate loan-risk sensitive insurance premiums.Design/methodology/approachThis paper takes a capped barrier option approach to the market valuation of the equity of the bank and the liability of the deposit insurer. The cap demonstrates the dynamics of a politically connected borrowing firm’s asset and highlights the truncated nature of loan payoffs. The barrier addresses that default can occur at any time before the maturity date. The bank participating in a government capital injection program is required to fund the politically connected firm that has preferential access to financing.FindingsPolitical connection as such makes the bank more prone to risk taking at a reduced interest margin, produces greater safety for the bank owing to government capital injections, and leads to increasing the fair deposit insurance premium. The positive effect of political connection on the deposit insurance premium, which ignores the cap and the barrier yields significant over-estimation.Originality/valueThe study on the politically connected borrowing firm shows that political connection is likely to affect the distressed bank’s performance, yielding the political-connection cost of a reduced bank interest margin and the political-connection benefit of a reduced bank equity risk, contributing the literature on political connection and bank bailout.

Shareholder Risk-Taking Incentives in the Presence of Contingent Capital

This paper presents a model of shareholders’ willingness to exert effort to reduce the likelihood of bank distress, and the implications of the presence of contingent convertible (CoCo) bonds in the liabilities structure of a bank. Consistent with the existing literature, we show that the direction of the wealth transfer at the conversion of CoCo bonds determines their impact on shareholder risk-taking incentives. We also find that ‘anytime’ CoCos (CoCo bonds trigger-able anytime at the discretion of managers) have a minor advantage over regulator CoCo bonds, and that quality of capital requirements can reduce the risk-taking incentives of shareholders. We argue that shareholders can also use manager-specific CoCo bonds to reduce the riskiness of the bank activities. The issuance of such bonds can increase the resilience of individual banks and the whole banking system. Regulators can use restrictions on conversion rates and/or requirements on the quality of capital to address the impact of CoCo bonds issuance on risk-taking incentives.

A PROPOSED MODEL FOR PREDICTING THE FINANCIAL DISTRESS OF PRIVATE CONVENTIONAL BANKS IN SYRIA: AN EMPIRICAL STUDY

This study aims to find the best set of financial ratios that can be used to predict the financial distress of private conventional banks in Syria and to distinguish between distressed and non-distressed banks in the first and second year before the distress. In order to warn the concerned parties to intervene and take corrective actions in a timely manner and to restore the health of these banking institutions. To achieve this, a stepwise discriminant analysis was used and 21 financial ratios were calculated for a sample of 11 banks for a period between the years (2010-2016). The following proposed model was reached: Z = 14.746 (D/A) + 35.069 (L/A) -15.899 (NFE/A) -5.134 (NPM) -26.076. Test of the model has been done, and it was found to be able to predict the financial distress and distinguish between distressed and non-distressed banks with an accuracy rate 100% in the first and second year before the distress.

Predicting Bank Distress in the UK with Machine Learning

Using novel data and machine learning techniques, we develop an early warning system for bank distress. The main input variables come from confidential regulatory returns, and our measure of distress is derived from supervisory assessments of bank riskiness from 2006 through to 2012. We contribute to a nascent academic literature utilising new methodologies to anticipate negative firm outcomes, comparing and contrasting classic linear regression techniques with modern machine learning approaches that are able to capture complex non-linearities and interactions. We find the random forest algorithm significantly and substantively outperforms other models when utilising the AUC and Brier Score as performance metrics. We go on to vary the relative cost of false negatives (missing actual cases of distress) and false positives (wrongly predicting distress) for discrete decision thresholds, finding that the random forest again outperforms the other models. We also contribute to the literature examining drivers of bank distress, using state of the art machine learning interpretability techniques, and demonstrate the benefits of ensembling techniques in gaining additional performance benefits. Overall, this paper makes important contributions, not least of which is practical: bank supervisors can utilise our findings to anticipate firm weaknesses and take appropriate mitigating action ahead of time.

Costs of Sovereign Defaults: Restructuring Strategies, Bank Distress and the Capital Inflow-Credit Channel

Costs of Sovereign Defaults: Restructuring Strategies, Bank Distress and the Capital Inflow-Credit Channel

Interbank Connections, Contagion and Bank Distress in the Great Depression

Interbank Connections, Contagion and Bank Distress in the Great Depression