The Z-score is dead, long live the Z-score! A new way to measure bank risk

Abstract

This paper raises questions about the consistency of the Z-score, which is the most applied accounting-based measure of bank risk. In spite of its main advantage, namely the concept of risk on which it relies, the traditional formula is precisely inconsistent with this concept. The Z-score is deduced from the probability that bank’s losses exceed its capital, but under the very unrealistic assumption of normally distributed returns on assets. Consequently, we propose a structural approach to determine this bank risk measure. It consists to define the default event when banks’ profit is lower than a default threshold level, which is based on the balance-sheet structure of banks and on new prudential regulation requirements