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Measuring bank risk: Forward-looking z-score

Bilal Hafeez, Xiping Li, M. Humayun Kabir and David Tripe

International Review of Financial Analysis, 2022, vol. 80, issue C

Abstract: While the z-score has been widely used to evaluate bank risk, it is criticized as a backward-looking measure. We propose a forward-looking method to construct the z-score by incorporating analyst forecasts. Empirical results show that the forward-looking z-score can predict the movement of the standard z-score one quarter ahead of time, and its predictive ability on banks' downward risk is better than the standard z-score. Moreover, we find that the predictive ability of the forward-looking z-score improves after the Dodd-Frank Act of 2010, especially for large banks, showing the consequences of strengthened regulation and transparency. The forward-looking z-score is also significantly associated with the probability of default and market-based risk measures and can provide predictive signals for banks' future profitability. Overall, our findings suggest that the forward-looking z-score mitigates the shortcomings of the standard z-score and provides a reliable early warning signal for banks' future risk and performance.

Keywords: Bank insolvency risk; Forward-looking z-score; Downward signal; Analyst forecast; Failure prediction (search for similar items in EconPapers)
JEL-codes: G20 G21 G28 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1016/j.irfa.2022.102039

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