Drivers of Bank Default Risk: Bank Business Models, the Sovereign and Monetary Policy

Abstract

In this paper we empirically analyze the determinants of bank default risk (measured by the banks’ CDS spreads) for European banks during the period 2008-2018. We examine the effect of (1) bank business model characteristics, (2) sovereign default risk and (3) ECB monetary policy. We disentangle the effect of monetary policy in a direct channel and an indirect effect operating through a sovereign risk channel. In terms of business model variables, we find that the capital ratio and the reliance on stable deposits lowers the perceived default risk of banks, while non-performing loans significantly increase the CDS spreads. Hence, the CDS market distinguishes resilient banks from risky banks. In terms of monetary policy, we document that accommodative ECB actions in general lower bank default risk. We also show that the downward effect of monetary policy on bank risk is mainly transmitted through the sovereign risk channel. Our findings confirm the importance of the Basel 3 capital and stable funding rules and they suggest policy implications in terms of bank business model choices as well as approaches to tackle the bank-sovereign loop in Europe.