Estimating volatility clustering and variance risk premium effects on bank default indicators

Abstract

Default risk increases substantially during financial stress times due to mainly the two reasons: volatility clustering and investors’ desire to protect themselves from such increases in volatility. It manifested in the aftermath of the Global Financial Crisis of 2008–2009 with unpleasant outcomes of many bankruptcies and severe financial distress. To account for these features, we adapted the structural credit risk approach to include both time-varying (return) volatility and risk premium about the return volatility itself. By applying the model to US banks, we obtain better bank default indicators in comparison to the benchmark models.