How Accurately Can Z-score Predict Bank Failure?

Abstract

Bank risk is not directly observable, so empirical research relies on indirect measures. We evaluate how well Z-score, the widely used accounting-based measure of bank distance to default, can predict bank failure. Using the U.S. commercial banks’ data from 2004 to 2012, we find that on average, Z-score can predict 76% of bank failure, and additional set of other bank- and macro-level variables do not increase this predictability level. We also find that the prediction power of Z-score to predict bank default remains stable within the three-year forward window.