Market Indicators Bank Fragility and Indirect Market Discipline
by Reint Gropp of the European Central Bank,
Abstract: We examine whether two commonly used indicators of bank fragility, the subordinated debt spread and KMV's distance to default, yield signals in line with supervisors' interests. We argue that supervisors would prefer indicators that are strictly increasing in earnings, and decreasing in leverage and earnings volatility. Using standard option pricing, we show that the two indicators do indeed satisfy these properties if the firm is still solvent. We also summarise the results from a test of these properties in a sample of EU banks during the 1990s. The results suggest that the distance to default signals bank fragility earlier than the subordinated debt spread. Also, the spread is affected by the implicit safety net of the bank. Finally, the results suggest that the indicators may add marginal value to accounting information through a reduction in Type II ("false positive") errors.
Keywords: Banking, Bank fragility, Market indicators, Market discipline.
Published in: Federal Reserve Bank of New York Economic Policy Review, Vol. 10, No. 2., (September 2004), pp. 53-62.