An Early Warning Model for EU banks with Detection of the Adverse Selection Effect

Olivier Brossard (), Frédéric DUCROZET (PSE - Crédit Agricole) and Adrian ROCHE (EconomiX - Crédit Agricole)

Cahiers du GRES from Groupement de Recherches Economiques et Sociales

Abstract: We estimate an early warning model of banks’ failure using a panel of 82 EU banks observed between 1991 and 2005. We make two contributions to the literature. Firstly, we construct a distance-to-default indicator and test its predictive power. The tests implemented here are very similar to those realized by Gropp, Vesala and Vulpes (2005), but our time dimension is four years longer and we use a more restrictive definition of banks’ “failure”. This first part of the paper establishes the accuracy of our data and confirms the robustness of distance-to-default as an early indicator of EU banks’ fragility. Our second advance consists in introducing a variable detecting the adverse selection problem that can be caused by rapid growth strategies. A measure of past average growth of assets is shown to be a very significant and powerful predictor of future banks’ difficulties. We discuss the origins and implications of such an effect.

Keywords: failures; early warning systems; CAMEL ratings; distance to default (search for similar items in EconPapers)
JEL-codes: G21 G33 G14 E58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-eec, nep-for and nep-mac
Date: 2007
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Persistent link: http://EconPapers.repec.org/RePEc:grs:wpegrs:2007-08

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