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

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.