Measuring bank risk: Forward-looking z-score

• Published in: International review of financial analysis 2022-03, Vol.80, p.102039, Article 102039
• Main Authors: Hafeez, Bilal, Li, Xiping, Kabir, M. Humayun, Tripe, David
• Format: Article
• Language: English
• Subjects: Analyst forecast; Bank insolvency risk; Downward signal; Failure prediction; Forward-looking z-score
• ISSN: 1057-5219; 1873-8079
• DOI: 10.1016/j.irfa.2022.102039

While the z-score has been widely used to evaluate bank risk, it is criticized as a backward-looking measure. We propose a forward-looking method to construct the z-score by incorporating analyst forecasts. Empirical results show that the forward-looking z-score can predict the movement of the standard z-score one quarter ahead of time, and its predictive ability on banks' downward risk is better than the standard z-score. Moreover, we find that the predictive ability of the forward-looking z-score improves after the Dodd-Frank Act of 2010, especially for large banks, showing the consequences of strengthened regulation and transparency. The forward-looking z-score is also significantly associated with the probability of default and market-based risk measures and can provide predictive signals for banks' future profitability. Overall, our findings suggest that the forward-looking z-score mitigates the shortcomings of the standard z-score and provides a reliable early warning signal for banks' future risk and performance. •We propose a forward-looking method to construct the time-varying z-score by incorporating analyst forecasts.•The forward-looking z-score predicts banks' insolvency risk one quarter ahead of time.•The predictive ability of the forward-looking z-score on banks' downward risk is better than the standard z-score.•The forward-looking z-score mitigates the shortcoming of the standard z-score being backward-looking.