Financial distress in Brazilian banks: An early warning model

Abstract

This study aims to propose an early warning model for predicting financial distress events in Brazilian banking institutions. Initially, a set of economic-financial indicators is evaluated, suggested by the risk management literature for identifying situations of bank insolvency and exclusively taking public information into account. For this, multivariate logistic regressions are performed, using as independent variables financial indicators involving capital adequacy, asset quality, management quality, earnings, and liquidity. The empirical analysis was based on a sample of 142 financial institutions, including privately and publicly held and state-owned companies, using monthly data from 2006 to 2014, which resulted in panel data with 12,136 observations. In the sample window there were nine cases of Brazilian Central Bank intervention or mergers and acquisitions motivated by financial distress. The results were evaluated based on the estimation of the in-sample parameters, out-of-sample tests, and the early warning model signs for a 12-month forecast horizon. These obtained true positive rates of 81%, 94%, and 89%, respectively. We conclude that typical balance-sheet indicators are relevant for the early warning signs of financial distress in Brazilian banks, which contributes to the literature on financial intermediary credit risk, especially from the perspective of bank supervisory agencies acting towards financial stability.