Measuring the Financial Soundness of US Firms, 1926-2012
Discussion
Simon Gilchrist
Boston Univerity and NBER
Bank of Portugal
June 12th, 2015

Overview
Use inverse of equity volatility as a proxy for default risk.
Useful approximation in a structural model.
Available over long time series.
Main Findings:
DI systematically related to credit spreads and default rates.
Extreme events: 1933, 1938, 2008.
Great Recession:
Volatility not leverage.
Banks and non-financials look very similar.
Broad conclusions:
Financial factors do not in general cause business cycles.
Idiosyncratic volatility not risk – “uncertainty” rather than
”endogenous volatility”.

Discussion
Distance to Insolvency vs Distance to Default:
DD t
= ln ( V t
/D t
) − µ t
+ 0 .
5 σ
2 t
σ t
Distance to Insolvency vs Excess Bond Premium
EBP – movements in credit spreads not due to default risk.
Interpretation

Distance to Insolvency (1973-2012)
1970m1 1980m1 1990m1 date
DI
2000m1
EBP
2010m1

Distance to Default: (1973-2012)
1970m1 1980m1 1990m1 date
DD_CRISP
2000m1
DD_GZ
2010m1

Leverage vs Volatility (1973-2012)
1970m1 1980m1 1990m1 date
E_V_GZ
2000m1 sigma_GZ
2010m1

Constant Leverage (1973-2012)
1970m1 1980m1
DD_GZ
1990m1 date
2000m1
DD_GZ_Constant
2010m1

Distance to Insolvency vs Distance to Default (1973-2012)
2
DI
4
DD_CRISP
Fitted values
6 8

Information Content: Forecasting one year ahead log Y t +12
− log Y t
= α o
+ α
1
X t
+ P
6 j =0 b j log Y t − j
+ ε t log IP t +12
− log IP t
U E t +12
− U E t
EBP t
-3.85
(0.53)
DD t
DI
R
2 t
0.83
(0.09)
0.74
(0.20)
-0.15
(0.04)
2.65
(1.02)
-0.25
(0.21)
0.30
0.24
0.23
0.49
0.40
0.38

VAR Impulse: Distance to Insolvency
Distance-to-insolvency
5
0
-5
-10
0 4 8 12 16 20 24 28 32 36
-15
Excess bond premium
Percentage points
0.15
0.10
0.05
0.00
0 4 8 12 16 20 24 28 32 36
-0.05
Industrial production
Percent
0.2
0.0
-0.2
-0.4
0 4 8 12 16 20 24 28 32 36
-0.6
Unemployment rate
Percent
0.3
0.2
0.1
0.0
0 4 8 12 16 20 24 28 32 36
-0.1
2-year treasury yield
Percent
0.1
0.0
-0.1
-0.2
-0.3
0 4 8 12 16 20 24 28 32 36
10-year treasury yield
Percent
0.10
0.05
0.00
-0.05
-0.10
-0.15
-0.20
-0.25
0 4 8 12 16 20 24 28 32 36

VAR Impulse: EBP
Distance-to-insolvency
0 4 8 12 16 20 24 28 32 36
2
1
0
-1
-2
-3
-4
Excess bond premium
Percentage points
0.4
0.3
0.2
0.1
0.0
0 4 8 12 16 20 24 28 32 36
Industrial production
Percent
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
0 4 8 12 16 20 24 28 32 36
Unemployment rate
Percent
0.4
0.3
0.2
0.1
0.0
0 4 8 12 16 20 24 28 32 36
2-year treasury yield
Percent
0.1
0.0
-0.1
-0.2
-0.3
0 4 8 12 16 20 24 28 32 36
10-year treasury yield
Percent
0.10
0.05
0.00
-0.05
-0.10
-0.15
-0.20
0 4 8 12 16 20 24 28 32 36

Interpretation of results
Large bank/broker-dealers take losses.
Intermediary asset pricing – liquidity dries up.
Some markets shut down (asset-backed CP)
Some markets become less liquid and more volatile
Bond markets
Equity markets
Bond markets provide better signals:
FI’s are specialists in bond market.
Bonds reflect downside rather than upside risk.
Liquidity premiums lead to greater financing costs – declines in investment and output.