Bank Risk Dynamics and Distance to Default

60 Pages Posted: 7 May 2019

See all articles by Stefan Nagel

Stefan Nagel

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research; CESifo (Center for Economic Studies and Ifo Institute)

Amiyatosh Purnanandam

University of Michigan, Stephen M. Ross School of Business

Multiple version iconThere are 3 versions of this paper

Date Written: May 2019

Abstract

We adapt structural models of default risk to take into account the special nature of bank assets. The usual assumption of log-normally distributed asset values is not appropriate for banks. Typical bank assets are risky debt claims, which implies that they embed a short put option on the borrowers' assets, leading to a concave payoff. This has important consequences for banks' risk dynamics and distance to default estimation. Due to the payoff non-linearity, bank asset volatility rises following negative shocks to borrower asset values. As a result, standard structural models in which the asset volatility is assumed to be constant can severely understate banks' default risk in good times when asset values are high. Bank equity payoffs resemble a mezzanine claim rather than a call option. Bank equity return volatility is therefore much more sensitive to big negative shocks to asset values than in standard structural models.

Suggested Citation

Nagel, Stefan and Purnanandam, Amiyatosh, Bank Risk Dynamics and Distance to Default (May 2019). CEPR Discussion Paper No. DP13715, Available at SSRN: https://ssrn.com/abstract=3383973

Stefan Nagel (Contact Author)

University of Chicago - Booth School of Business ( email )

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research ( email )

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CESifo (Center for Economic Studies and Ifo Institute) ( email )

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Amiyatosh Purnanandam

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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