Estimating volatility clustering and variance risk premium effects on bank default indicators

Abstract

Default risk increases substantially during financial stress times due to mainly the two reasons: volatility clustering and investors' desire to protect themselves from such increases in volatility. It manifested in the aftermath of the Global Financial Crisis of 2008-2009 with unpleasant outcomes of many bankruptcies and severe financial distress. To account for these features, we adapted the structural credit risk approach to include both time-varying (return) volatility and risk premium about the return volatility itself. By applying the model to US banks, we obtain better bank default indicators in comparison to the benchmark models.