{
  "title": "Distance-to-Default in Banking: A Bridge Too Far?",
  "publication": "IMF Working Papers, September 1, 2006",
  "sourceUrl": "https://www.imf.org/en/publications/wp/issues/2016/12/31/distance-to-default-in-banking-a-bridge-too-far-19863",
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  "summary": "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.",
  "sections": [
    {
      "heading": "Summary",
      "content": "- Contrasts corporate defaults (where firms can default directly) with banking: regulators typically take statutory actions to avoid large fiscal costs associated with bank defaults.\n- 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.\n- Introduces distance-to-capital as a concept that accounts for pre-default regulatory actions such as those in a prompt-corrective-actions framework.\n- 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.\n- Uses the framework to illustrate pre-default regulatory actions in Japan in 2001-03."
    },
    {
      "heading": "Key findings and contributions",
      "content": "- Distance-to-default omits regulatory intervention and therefore may misstate default risk for banks relative to nonfinancial corporates.\n- Distance-to-capital extends market-based risk measurement by incorporating regulatory triggers and pre-default statutory actions.\n- The divergence between the two measures depends explicitly on:\n  - the level of capital adequacy thresholds, and\n  - asset volatility.\n- Application: the framework is applied to real-world regulatory actions in Japan in 2001-03 to illustrate pre-default interventions."
    },
    {
      "heading": "Theoretical framework and methodology",
      "content": "- Both distance-to-default and distance-to-capital are cast within a single theoretical framework that allows direct comparison.\n- The framework models how regulatory capital adequacy thresholds and asset volatility alter the effective default trigger for banks relative to corporates.\n- Distance-to-capital effectively shifts the default barrier to reflect pre-default regulatory actions embedded in frameworks like prompt-corrective-actions."
    },
    {
      "heading": "Policy implications and recommendations",
      "content": "- Market-based measures of bank credit risk should incorporate regulatory intervention thresholds to better reflect true solvency risk.\n- Supervisory frameworks (for example, prompt-corrective-actions) materially affect measured default distances; risk monitoring and stress-testing should account for these effects.\n- Regulators and market participants should use distance-to-capital alongside distance-to-default to capture both market perceptions and regulatory mechanics."
    },
    {
      "heading": "Case illustration: Japan 2001-03",
      "content": "- 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.\n- 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.\n\nSource: Amadou N Sy and Jorge A Chan-Lau, IMF Working Paper (September 1, 2006).\n\n---\n\n Content in this bundle\n\n- Wp06215\n  - Wp06215 (Markdown version){rel=\"alternate\" type=\"text/markdown\"}\n  - Wp06215 (PDF){rel=\"external\" type=\"application/pdf\"}\n\n---\n\nSource: https://www.imf.org/en/publications/wp/issues/2016/12/31/distance-to-default-in-banking-a-bridge-too-far-19863"
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    "Authors: Amadou N Sy, Jorge A Chan-Lau",
    "Published: September 1, 2006",
    "Series: IMF Working Papers",
    "DOI: https://doi.org/10.5089/9781451864755.001",
    "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:",
    "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.",
    "**Wp06215**"
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