Equity and Bond Market Signals as Leading Indicators of Bank Fragility

Abstract

We analyse the ability of the distance to default and subordinated bond spreads to signal bank fragility in a sample of EU banks. We find leading properties for both indicators. The distance to default exhibits lead times of 6–18 months. Spreads have signal value close to problems only. We also find that implicit safety nets weaken the predictive power of spreads. Further, the results suggest complementarity between both indicators. We also examine the interaction of the indicators with other information and find that their additional information content may be small but not insignificant. The results suggest that market indicators reduce type II errors relative to predictions based on accounting information only.