Banks’ Risk Dynamics and Distance to Default

We adapt structural models of default risk to take into account the special nature of bank assets. The usual assumption of lognormally distributed asset values is not appropriate for banks. Typical bank assets are risky debt claims with concave payoffs. Because of the payoff nonlinearity, bank asset...

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Bibliographic Details
Published in:The Review of financial studies 2020-06, Vol.33 (6), p.2421-2467
Main Authors: Nagel, Stefan, Purnanandam, Amiyatosh
Format: Article
Language:English
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Summary:We adapt structural models of default risk to take into account the special nature of bank assets. The usual assumption of lognormally distributed asset values is not appropriate for banks. Typical bank assets are risky debt claims with concave payoffs. Because of the payoff nonlinearity, bank asset volatility rises following negative shocks to borrower asset values. As a result, standard structural models with constant asset volatility can severely understate banks’ default risk in good times when asset values are high. Additionally, bank equity return volatility is much more sensitive to negative shocks to asset values than in standard structural models.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhz125