Estimating Default Probabilities Using Stock Prices: The Swedish Banking Sector During the 1990s Banking Crisis

The growing interest in management of credit risk and estimation ofdefault probabilities has given rise to a range of more or lesselaborate credit risk models. Hall and Miles (1990) suggests an approachof estimating failure probabilities based solely on stock market prices.The approach has the advantage of simplicity but relies on markete.ciency to hold. In this paper we suggest an extension to the Hall andMiles (1990) model using extreme value theory and apply the extendedmodel to the Swedish financial sector and to individual Swedish banks.The 15- year long sample in our study covers the period of the Swedishbanking crisis of the early 1990s. We find a close correspondencebetween changes in the estimated probabilities of failure and the actualcredit events occurring. Credit ratings from major credit ratingagencies, on the other hand, are shown to react much less and muchslower to credit quality changes.