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

_IMF Working Papers, September 1, 2006_

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## Bibliographic details
- Authors: Amadou N Sy, Jorge A Chan-Lau
- Published: September 1, 2006
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451864755.001

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### Summary
- 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.

### Key findings and contributions
- 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.

### Theoretical framework and methodology
- 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.

### Policy implications and recommendations
- 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.

### Case illustration: Japan 2001-03
- 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).*

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/distance-to-default-in-banking-a-bridge-too-far-19863_