Comparing Bank Risk Measures

Full note available here.

Bank counter-party risk became a major issue for many market participants during the recent financial crisis. The risk was complex and involved multiple dimensions. Fluctuations in risk occurred not just as the financial state of banks fluctuated but also because the capacity and willingness of sovereigns to rescue banks changed over time.

Major corporates, non-bank financial firms and public bodies such as central banks struggled to monitor and manage bank counter-party risk during the crisis. Many made changes in their bank-related risk policies including altering the ways in which they set limits for bank counter-parties.

The risk of defaults by banks has significantly abated since the crisis as is evidenced by declines in spreads on bank debt and Credit Default Swaps (CDS). The reduction in such risks reflects the tightening of bank regulation since the crisis especially in the areas of capital and liquidity rules. But bank credit risk remains important and market participants should consider whether they have in place the infrastructure and procedures necessary for measuring bank credit risk in an accurate and timely fashion.

This note provides perspectives on different measures of credit risk applicable to bank exposures. We compare several approaches to, specifically (i) agency ratings, (ii) a combination of simple financial ratios suggested by regulators, (iii) Merton-style default probability estimates based on equity to liability ratios, and (iv) spreads on CDS.

The note is organised as follows. Section 1 describes the four credit risk indicators on which we focus. Section 2 gives information on the illustrative sample of banks we study. Section 3 presents results on how the risk measures have performed since the crisis. Section 4 concludes.

This paper was presented at the World Bank Executive Forum.  Click here for presentation slides.