Working Paper: CEPR ID: DP13715
Authors: Stefan Nagel; Amiyatosh Purnanandam
Abstract: We adapt structural models of default risk to take into account the special nature of bank assets. The usual assumption of log-normally distributed asset values is not appropriate for banks. Typical bank assets are risky debt claims, which implies that they embed a short put option on the borrowers’ assets, leading to a concave payoff. This has important consequences for banks’ risk dynamics and distance to default estimation. Due to the payoff non-linearity, bank asset volatility rises following negative shocks to borrower asset values. As a result, standard structural models in which the asset volatility is assumed to be constant can severely understate banks’ default risk in good times when asset values are high. Bank equity payoffs resemble a mezzanine claim rather than a call option. Bank equity return volatility is therefore much more sensitive to big negative shocks to asset values than in standard structural models.
Keywords: No keywords provided
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Bank asset values (G21) | Default risk (G33) |
| Merton model assumptions (D80) | Underestimation of default risk (G33) |
| High asset values (G19) | Increased asset volatility (G19) |
| Increased asset volatility (G19) | Default risk (G33) |
| Modified model structure (C59) | Increased equity volatility (G19) |
| Negative shocks (E32) | Increased equity volatility (G19) |
| Economic booms (E32) | Underestimation of government guarantees value (H81) |