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Distance-to-default measures and determinants for systemically important financial institutions

Natalya A. Schenck

Journal of Financial Regulation and Compliance

ISSN: 1358-1988

Article publication date: 6 May 2014

641

Abstract

Purpose

This study aims to compare two distance-to-default methods, data-transformed maximum likelihood estimation and “naïve”, that are suitable for financial institutions. The links between these measures and asset size, Tier 1 and Tier 2 capital ratios, non-performing assets and operating efficiency have been examined and an alternative default risk measure has been introduced. Most of the market-based distance-to-default measures are not appropriate for banks due to their unique debt structure.

Design/methodology/approach

The author has compared two distance-to-default measures and has identified their accounting determinants using Pearson’s correlation and regressions with clustered standard errors. The sample of the US-based systemically important financial institutions covers the period from 2000 to 2010.

Findings

Non-performing assets and operating efficiency are found to be statistically and economically significant determinants of both distance-to-default measures. Tier 1 capital ratio is not a significant indicator of default risk.

Practical implications

The results emphasize the importance of using a combination of market-based default risk measures and accounting ratios in default prediction models for the financial institutions.

Originality/value

This paper identifies accounting determinants of two distance-to-default measures for large financial institutions, before and during the 2008 financial crisis. It introduces a spread between two measures as an alternative default risk indicator.

Keywords

Citation

A. Schenck, N. (2014), "Distance-to-default measures and determinants for systemically important financial institutions", Journal of Financial Regulation and Compliance, Vol. 22 No. 2, pp. 159-172. https://doi.org/10.1108/JFRC-02-2013-0004

Publisher

:

Emerald Group Publishing Limited

Copyright © 2014, Emerald Group Publishing Limited

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