A Note on Banks and Sovereign CDS Premia Dynamics: Market Reactions and Determinants

Abstract

Following the upset of the financial crisis, and especially after the collapse of Lehman Brothers, Governments in advanced economies have provided support to the fi nancial sector to help restoring its normal functioning and to avoid the widening of the meltdown. Banking CDS premia climbed from July 2007, while after the September 2008. Both prices started to have a broad comovement from the Lehman Brothers collapse, with a reduction in their differences. Furthermore, the differences between banking and CDS premia for PIIGS become negative. This study examines the relation between and banking CDS premia after July 2007 by analyzing both market reactions and the determinants of the spread between these premia. By using an event study approach, we find that: for a negative (positive) event related to a specific bank or to the banking sector, market reacts with an increase (decrease) in spreads for both the targeted and the other competitors, while premia do not change considerably; for a negative (positive) event related to countries, only CDS for PIIGS and their banking sector increase (decrease); the release of the stress test for European leads to a reduction in CDS premia for almost all in our sample. On the other hand, we search for determinants of the spread in CDS premia between banking and sectors. We find that iTraxx Europe and SovX Western Europe (as common risk factors), VSTOXX (as the market risk aversion proxy) and the ratio between the European equity index for and the overall European equity index (as a proxy for the financial sector vulnerability) are useful determinants for our basis. Moreover, the German Bund is equally important. Finally, the presence of three determinants for the basis banks vs sovereign is confirmed by a principal component analysis.