Market Indicators, Bank Fragility, and Indirect Market Discipline

[...]This paper aims to ascertain the quality (that is, thepredictive power and prediction errors) of two marketindicators: the distance to default and the subordinated debtspread. Previous work has established that banks’ marketprices reflect contemporaneous information about bank riskin the United States and in Europe.2 In our study, we firstexamine the theoretical properties of the indicators, namely,whether or not they are aligned with the conservativeobjectives of supervisors. We propose that in order to bealigned with these objectives, market indicators of bankfragility should be decreasing in earnings expectations, andincreasing in earnings volatility and leverage. Using simpleoption-pricing theory, we show that the subordinated debtspread and the negative distance to default do indeed satisfy these properties.3 We also find that the signal-to-noise ratio ofsubordinated debt spreads should be quite low far away fromthe default point of the bank. We then summarise the resultsobtained in Gropp, Vesala, and Vulpes (2002), which suggestthat both indicators may have some usefulness in predictingbank fragility in the European Union (EU).[...]