Equity and Bond Market Signals as Leading Indicators of Bank Fragility

Abstract

We analyse EU banks' equity market-based distances-to-default and subordinated bond spreads in the secondary market in relation to their capability of signalling a material weakening in banks' financial condition. Both indicators are demonstrated to be complete indicators of bank fragility, reflecting relevant information of default risk; and also to be aligned with the supervisors' conservative perspective. We use two different econometric models: a logit-model, estimated for a number of different time-leads, and a Cox proportional hazard model. We find support in favour of using both the distance-to-default and spread as leading indicators of bank fragility, regardless of our econometric specification. However, while we find robust predictive performance of the distance-to-default between 6 to 18 months in advance, its predictive properties are quite poor closer to the "default" events. In contrast, all banks' subordinated debt spreads seem to have signal value, but close to the "default" events only. Otherwise, they appear to be significantly diluted by the expectation of public bailout, which is not the case with the equity market-based distances-to-default.

Keywords: Banking, Bank fragility, Market Indicators

JEL Classification: G21, G12