The Market's View on the Probability of Banking Sector Failure: Cross-Country Comparisons

Considering the increasingly international banks of today, the health of a country's banking sector is crucial not only to the country's growth and prosperity but also to the rest of the international financial community. Early warning signals of a banking sector in trouble or a pending banking crisis would therefore be of great value to both banks, investors and banking regulators/supervisors world wide. Different warning signals exist and in this paper we investigate how the stock market can provide a market-based indicator of banking sector health. Hall and Miles (1990) suggests an approach of estimating default probabilities of individual banks using only their stock market valuations and volatilities. In this paper we apply an aggregated version of their approach to banking sectors around the world in both developed and emerging economies and study the market's assessment of the probability of systemic banking crises in these countries over the last decade, including the Asian Crisis 1997-98. In addition, we investigate whether there is a relationship between the probability of banking sector failure and institutional/structural features of the actual banking sector. The quality of governance and the degree of law and order in a country is found to be significantly negatively related to the market based failure probabilities as is an explicit deposit insurance during periods of crisis.