Page 23 - Monocle Quarterly Journal Vol 1 Issue 1 Q4

the ARt of fAIluRe: pRedIctING fINANcIAl dIStReSS pRe-cRISIS
for such institutions in December 2007 was unavailable. Performance between 1 January 2008 and 1 November 2009 was used to identify banks that became distressed.
McKinsey de ned banks as being Financially Distressed if any one of the following four criteria were met: where banks had declared bankruptcy, been placed into government receivership, been acquired under duress, or received bailout capital in excess of 30 percent of their Tier-1 equity.
A range of nancial and risk ratios were then calculated as of 31st December 2007 to determine their ability to predict nancial distress. McKinsey found that the tangible common equity (TCE) to risk- weighted assets (RWA) ratio was the best predictor of future distress.
Monocle’s Use of e Banker List of Top 1000 Banks
Whilst we believe this was a good starting point, we were concerned that they had not established a clear default frequency for the top 1000 banks. In fact, we could nd no study that had been conducted across the worlds’ top 1000 banks in terms of a frequency of default post the largest single nancial crisis since the Great Depression. We therefore conducted initial analysis work to simply calculate what the default frequency of banks was during and post-crisis based on the McKinsey de nition. We also decided to use a longer observation period, from 2008 through to 2010, and across the top 1000 banks.
For each of the 1000 banks on e Banker List (2007), an investigation was conducted into the status of each bank from the 1st of January 2008 through to the 30th of June 2010, identifying whether any of the McKinsey criteria for nancial distress were met by the speci c bank in the de ned time period. Banks were identi ed as being either Financially Distressed (FD) or Non-Financially Distressed (NFD). e results are surprising – out of the top 1000 banks investigated, 106 banks conform to the de nition of Financial Distress. is result implies that the e ective default frequency for banks during the Financial Crisis 2007/8 was in excess of a staggering 10 percent. To put this number into perspective, recall that a poor performing mortgage book in a classic retail banking environment would be of the order of 2–3 percent during the height of the crisis. e default frequencies that caused the ripple e ect into the MBS market and the CDO market were of the order of 10–15 percent in the worst performing areas of the United States, such as Las Vegas.
“ e results are surprising – out of the top 1000 banks investigated, 106 banks conform to the de nition of Financial Distress.”
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