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

Chan-Lau, Jorge A.; Sy, Amadou Nicolas Racine

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

IMF Working Paper No. 06/215

19 Pages Posted: 31 Oct 2006

See all articles by Jorge A. Chan-Lau

Jorge A. Chan-Lau

International Monetary Fund (IMF) - International Capital Markets Department; National University of Singapore (NUS) - Risk Management Institute; Tufts University - Fletcher School of Law and Diplomacy

Amadou Nicolas Racine Sy

International Monetary Fund (IMF) - International Capital Markets Department; Brookings Institution

There are 2 versions of this paper

Date Written: September 2006

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, ignores 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 in a prompt-corrective-actions framework. We show that both risk measures can be analyzed 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 2001-03.

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

JEL Classification: G12, G21

Suggested Citation: Suggested Citation

Chan-Lau, Jorge Antonio and Sy, Amadou Nicolas Racine, Distance-to-Default in Banking: A Bridge Too Far? (September 2006). IMF Working Paper No. 06/215, Available at SSRN: https://ssrn.com/abstract=941277