Predicting Bank Defaults

As described in Chapter 1, there has been considerable success at predicting default and credit relative value for commercial and industrial firms using Merton-type structural models, such as Moody’s/ KMV (Vasicek, 1988; Kealhofer, 1999) model and Citi’s HPD model (Sobehart and Keenan, 2002; 2003). However, generating accurate model-based estimates of PDs for financial firms has proven difficult. Some reasons for this include financials’ high levels of leverage, the relative opacity of their assets and liabilities, potential support from governments, extreme risk of “tail events” and regulatory changes. Since the financial crisis of 2008–09 and the subsequent downgrade of many financial firms, investors have been increasingly interested in better assessing and managing their credit exposure to financial institutions. Also, the US Office of the Comptroller of the Currency (OCC), in accordance with the Dodd–Frank Act, has published final rules (Department of the Treasury, 2012) that remove references to credit ratings from its regulations pertaining to investment securities, securities offerings and foreign bank capital equivalency deposits.¹¹Section 939A of the Dodd–Frank Act