Distance-to-Default in Banking: A Bridge Too Far?

Abstract:     
In contrast to corporate defaults, regulators typically take a number of statutory actions to avoid the large fiscal costs associated with bank defaults. The distance-to-default, a widely used market-based measure of corporate default risk, overlooks such regulatory actions. To overcome this limitation, this paper introduces the concept of distance-to-capital that accounts for pre-default regulatory actions such as those prescribed in a prompt-corrective-actions framework. We show that both risk measures can be analysed using the same theoretical framework but differ depending on the level of capital adequacy thresholds and asset volatility. We also use the framework to illustrate pre-default regulatory actions in Japan in 2001-2003.

Keywords: Banks, insolvency, closure, prompt corrective action, distance-to-default, distance-to-capital

JEL Classification: G12, G21

Accepted Paper Series