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

IMF Working Papers, September 1, 2006

Source details

Contrasts corporate defaults (where firms can default directly) with banking: regulators typically take statutory actions to avoid large fiscal costs associated with bank defaults.
Identifies a limitation of the distance-to-default measure: it is a market-based measure of corporate default risk that ignores pre-default regulatory actions in banking.
Introduces distance-to-capital as a concept that accounts for pre-default regulatory actions such as those in a prompt-corrective-actions framework.
Shows that distance-to-default and distance-to-capital can be analyzed using the same theoretical framework but differ depending on capital adequacy thresholds and asset volatility.
Uses the framework to illustrate pre-default regulatory actions in Japan in 2001-03.

Distance-to-default omits regulatory intervention and therefore may misstate default risk for banks relative to nonfinancial corporates.
Distance-to-capital extends market-based risk measurement by incorporating regulatory triggers and pre-default statutory actions.
The divergence between the two measures depends explicitly on:
- the level of capital adequacy thresholds, and
- asset volatility.
Application: the framework is applied to real-world regulatory actions in Japan in 2001-03 to illustrate pre-default interventions.

Both distance-to-default and distance-to-capital are cast within a single theoretical framework that allows direct comparison.
The framework models how regulatory capital adequacy thresholds and asset volatility alter the effective default trigger for banks relative to corporates.
Distance-to-capital effectively shifts the default barrier to reflect pre-default regulatory actions embedded in frameworks like prompt-corrective-actions.

Market-based measures of bank credit risk should incorporate regulatory intervention thresholds to better reflect true solvency risk.
Supervisory frameworks (for example, prompt-corrective-actions) materially affect measured default distances; risk monitoring and stress-testing should account for these effects.
Regulators and market participants should use distance-to-capital alongside distance-to-default to capture both market perceptions and regulatory mechanics.

The paper uses the proposed framework to illustrate how pre-default regulatory actions in Japan in 2001-03 affect the assessment of banking-sector default risk.
The Japan example demonstrates how regulatory intervention can alter the timing and likelihood of bank failures relative to what distance-to-default alone would indicate.

Source: Amadou N Sy and Jorge A Chan-Lau, IMF Working Paper (September 1, 2006).