Early Warning Models for Bank Supervision: Simpler Could Be Better

ECONOMIC REVIEW-FEDERAL RESERVE BANK OF …, 2007

Journal of Banking Regulation

One of the major goals of bank supervisors is to predict bank distress events. As the environment changes, it is crucial to reassess and improve the models used in monitoring banks. The financial soundness of banks is traditionally assessed based on accounting ratios. However, the incorporation of market information in these models may significantly improve its ability to predict bank distress. The present paper has two main objectives, the first is to assess if market information adds value to accounting-based monitoring models when the purpose is to detect bank distress situations. Further, it also seeks to understand if the predictive power of market signals increased with transparency requirements. To accomplish this purpose, a total of 81 distress events from a sample of 248 European banks between 2008 and 2020 were analyzed. First, a logit univariate analysis was used to evaluate the relevance of each accounting and market variable. Then, the optimal multivariate accounting-based model to predict distress events was constructed using a stepwise approach. Finally, the previous model was extended to include the relevant market variables. The results support the use of market variables in bank monitoring models. Further, the present study provides evidence that the predictive power of market variables increased after the strengthening of the information requirements set by the Basel agreements. It can be concluded that the results support the use of market information for banking supervisory purposes, especially, in transparent markets.

2001

This paper assesses the extent to which stock market information may assist bank regulators in the identification of bank financial distress. The research identifies a variety of stock return and other market related variables that might contain elements of longerterm trends capable of anticipating changes in regulator ratings of bank and thrift financial health. Univariate tests confirm a remarkable tendency for market related variables to decline, or otherwise move, far in advance of formal regulator rating downgrades, suggesting that these variables may have useful predictive content.

2012

SSRN Electronic Journal, 2004

Bank supervisors in the United States conduct comprehensive on-site inspections of bank holding companies and assign them a supervisory rating meant to summarize their overall condition. We develop an empirical forecasting model of these ratings that combines accounting and financial market data. We find that securities market variables, such as stock returns and changes in bond yield spreads, improve the model's in-sample fit. Both equity and debt market variables are useful for explaining upgrades and downgrades. We conclude that stock and bond market investors possess different, but complementary information about bank holding company condition. However, in out-of-sample forecasting, we find that the forecast accuracy of the model with both equity and debt variables is little different from the accuracy of a model based on accounting and lagged supervisory information alone. Acknowledgments: The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of San Francisco or the Federal Reserve System. We thank Rob Bliss for generously sharing his bank holding company debt database with us. We thank Fred Furlong, Reint Gropp, and seminar participants at the Bank of England, the Basel Committee's Research Task Force on Banking Supervision, and the Chicago Conference on Bank Competition and Structure for helpful suggestions. We thank Judy Peng, Ryan Stever, and Chishen Wei for research assistance.

Economic Policy Review, 1998

This paper examines the possibility of providing an early warning model for commercial banking sub-sector with the hope that appropriate as well as effective strategies could be adopted to resolve crises promptly before they precipitate into failure. Data were collected for this purpose from thirty-two commercial banks using their 1996 and 1997 Financial Reports. The banks are divided into two groups: distressed and healthy. The study relied on a variety of accounting ratios in developing univariate (independent t-test) model in order to explain the causes of distress and whether any difference exists between distressed and healthy banks. This analysis confirms that there is a significant difference between distress and healthy banks. The univariate model using independent t-test shows that distressed and healthy commercial banks are significantly different in respect of eight ratios at 1 percent and 5 percent levels of significance. To study concludes that an early warning model developed in this study could be used by various stakeholders to monitor distress-proneness, direct attention to laggard areas for remedial action, and adjust their relationships where necessary.

2019

Since the outbreak of the global financial crisis, a number of regulations have been issued to cope with the too-big-to-fail problem and its devastating effects on financial markets, government budgets and the broader economy in general. The aim of these regulations is to contain the risks stemming from large institutions which potentially jeopardize not only these institutions' own existence but other institutions and segments of the economy as well. In particular, new legislation in macroprudential supervision and resolution that refers to systemically relevant institutions addresses the too-big-to-fail problem. Still, in practice, it is difficult for supervisory authorities to answer the question which institution may really compromise financial stability. The identification of systemically relevant banks is particularly important for banking systems (like the Austrian) with large numbers of banks, where even medium-sized banks might put stress on the entire financial system. Bringing together macroprudential regulations as well as recovery and resolution planning, this methodological paper aims to contribute to the literature and supervisory practice on the identification of systemically relevant banks. We develop a consistent and comprehensive framework that consists of more than 30 quantitative indicators reflecting four key stability criteria: financial market conditions, economic importance, direct contagion and indirect contagion. A particular challenge in this context is the setting of explicit thresholds for each of these indicators. To resolve this issue, we design a methodological approach to calibrating thresholds for different types of indicators: stress indicators, risk exposure indicators, system share indicators and network indicators. We identify thresholds based on quarterly panel data (from 1999 to 2016) for the Austrian banking sector. One basic assumption of our calibration is the idea of substitutability: If market activities of a failing bank can be absorbed promptly by other market participants, financial stability will not be at risk. As the substitution of bank activities also depends on the current phase of the economic cycle, we account for bust phases by developing stress scenarios.

North American Review of Economics and Finance, 1990

This paper uses five financial accounting ratios with three alternative loan-portfolio diversification measures to classify failures among small commercial banks that occurred during 1984. Classifications for one, two and three years before failure are performed using linear probability, logit, probit, and discriminant analysis models. Validation is done through the U-Method. The results indicate that the logit and probit functional forms may offer an advantage over the more frequently used discriminant analysis. U-Method classification accuracy is approximately 86 percent for the logit and probit models. The number of commercial bank failures has risen dramatically since the mid-70s. Today, more bank failures are taking place than at any other point in time since the mid-1930s. In itself, the number of bank failures should not be a concern in an otherwise efficient market. If these failures were the result of healthy competition, efficient-market advocates would argue that the market would have anticipated the failures based upon the available information.

Review of World Economics, 2003

The Wharton Financial Institutions Center The Wharton Financial Institutions Center provides a multidisciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest.