Bank CDS Research Articles

ECB Monetary Policy and the Term Structure of Bank Default Risk

Euro Area banks have been confronted with unprecedented monetary policy actions by the ECB. Monetary policy may affect bank risk profiles, but the consequences may differ for short-term risk versus long-term or structural bank risk. We empirically investigated the association between the ECB’s monetary policy stance and market-perceived short-term and long-term bank risk, using the term structure of default risk captured by bank CDS spreads. The results demonstrated that, during the period 2009–2020, ECB expansionary monetary policy diminished bank default risk in the short term. However, we did not observe a similar decline in long-term bank default risk, since we documented that monetary stimulus is associated with a steepening of the bank default risk curve. The reduction of bank default risk was most pronounced during the sovereign debt crisis and for periphery Euro Area banks. From 2018 onwards, monetary policy accommodation is associated with increased bank default risk, both short-term and structurally, which is consistent with the risk-taking hypothesis under which banks engage in excessive risk-taking behavior in their loan and securities portfolios to compensate profitability pressure caused by persistently low rates. The increase in perceived default risk is especially visible for banks with a high reliance on deposit funding.

ECB monetary policy and bank default risk☆

We empirically analyze the effect of ECB monetary policy on bank default risk, captured by bank CDS spreads, of Euro Area banks during the period 2008–2018. We disentangle the impact of monetary policy in a direct channel and an indirect effect operating through a sovereign risk channel. We document that accommodative ECB policies in general lower bank default risk. ECB policy actions exert their beneficial effect on the banks’ perceived risk profile through a combination of a direct effect and an indirect-through-the-sovereign effect. We demonstrate that these effects are stronger for banks in peripheral countries of the Euro Area and that the downward effect on bank default risk was especially pronounced in the 2012–2014 sovereign stress period. Yet, our time-varying impact analysis shows that the beneficial effect of ECB policy persists in the post-2014 era during which the ECB implemented its asset purchase program and other unconventional tools. Our results support the argument that, on balance, the beneficial effects of accommodative ECB monetary policy on Euro Area banks’ risk profile outweigh any negative side-effects.

Determinants of European banks’ default risk

Using bank CDS spreads, we examine three types of determinants of Euro Area bank default risk in the period 2008–2019: bank characteristics related to new regulation, the bank-sovereign nexus and the monetary policy stance. We find that Basel 3 regulation improves the banks’ risk profile since higher capital ratios and more stable deposit funding contribute significantly to lower CDS spreads. We confirm the persistence of the bank-sovereign interconnectedness and find that sovereign default risk is transmitted to bank risk with an amplification factor. The ECB monetary policy stance is neutral with respect to bank risk, hence we find no evidence of perceived excessive risk-taking behavior.

Policy uncertainty, interest rate environment and the dynamic correlation between sovereign and bank default risk

This study assesses the impact of policy uncertainty and the interest rate environment on the sovereign-bank nexus considering 48 banks in 14 countries. By applying principal component analysis to bank CDS premia in a country, the dynamic conditional correlation between sovereign CDS premia and the common variation underlying bank CDS is specified. Fixed effects panel regression analysis shows that the sovereign-bank correlation significantly increases in times of great policy uncertainty, low bank interest margins, high interbank market rates, and a low ratio of bank Tier 1 capital.

Bank credit risk events and peers' equity value

This paper documents a negative cross-transmission of bank-idiosyncratic credit risk events to the equity value of peers comprising other banks, insurance and real estate firms inter alia. Large jumps in the idiosyncratic component of bank CDS spreads significantly reduce the equity value of peers, particularly on the event day. The negative externality does not hinge on the “information connectedness” between the two entities as proxied by characteristics such as common core line of business, common country or region, and inter-country common legal tradition. The negative externality is stronger in turmoil market conditions when risk-aversion levels are higher and/or investors are subject to pessimism. The more fragile the risk profile of the event bank and peer firm prior to the event the stronger the cross-transmission. The findings lend support to the wake-up call paradigm at micro level, and are insightful towards a better assessment of the vulnerability of the financial system.

Financial stress in lender countries and capital outflows from emerging market economies

We investigate if financial stress in countries where international banks are headquartered is a major driver of the withdrawal of these banks’ credit to emerging market economies (EMEs). We find that when financial stress, measured by sovereign or bank CDS spreads or corporate bond spreads, increases, international banks decrease their lending to EMEs, which acts as a major driver of capital outflows from EMEs. In particular, financial stress in lender countries is a more important driver than the local financial conditions and macroeconomic fundamentals of EMEs. Such results hold for both the countries that experienced crises and those that did not, during the Global Financial Crisis (GFC). Such results also generally hold even after the GFC period, but to a lesser extent. Our findings suggest that it is desirable for EME policymakers to promote diversification of lender countries.

Funding liquidity, credit risk and unconventional monetary policy in the Euro area: a GVAR approach

This paper investigates the transmission of funding liquidity shocks, credit risk shocks and unconventional monetary policy within the Euro area. To this aim, a financial GVAR model is estimated for Germany, France, Italy and Spain on monthly data over the period 2006-2017. The interactions between repo markets, sovereign bonds and banks' CDS spreads are analyzed, explicitly accounting for the country-specific effects of the ECB's asset purchase programmes. Impulse response analysis signals core-periphery heterogeneity and persistent flight to quality. A simulated reduction in any ECB programme ultimately results in rising yields and bank CDS spreads in Italy and Spain, as well as in falling repo trade volumes and rising repo rates in all four countries.

Economic Policy Uncertainty, Interest Rates and the Co-Movement of Sovereign-Bank Default Risk

This study assesses the impact of policy uncertainty and the interest rate environment on the sovereign-bank nexus considering 48 banks in 14 countries. By applying principal component analysis to bank CDS premia in a country, the dynamic conditional correlation between sovereign CDS premia and the common variation underlying bank CDS is specified. Fixed effects panel regression analysis shows that the sovereign-bank correlation significantly increases in times of great policy uncertainty, low bank interest margins, high interbank market rates, and a low ratio of bank Tier 1 capital.

Bank Credit Risk Events and Peers’ Equity Value

This paper documents a negative cross-transmission of bank-idiosyncratic credit risk events to the equity value of peers comprising other banks, insurance and real estate firms inter alia. Large jumps in the idiosyncratic component of bank CDS spreads significantly reduce the equity value of peers, particularly on the event day. The negative externality does not hinge on the “information connectedness” between the two entities as proxied by characteristics such as common core line of business, common country or region, and inter-country common legal tradition. The negative externality is stronger in turmoil market conditions when risk-aversion levels are higher and/or investors are subject to pessimism. The more fragile the risk profile of the event bank and peer firm prior to the event the stronger the cross-transmission. The findings lend support to the wake-up call paradigm at micro level, and are insightful towards a better assessment of the vulnerability of the financial system.

Evaluating sovereign risk spillovers on domestic banks during the European debt crisis

Using a Markov-switching model with time-varying probabilities, spillovers from sovereign to domestic bank CDS spreads during the European debt crisis for a set of 14 European countries and 30 European banks are investigated. Our model is able to capture how the increased sovereign risk observed between 2010 and 2013 throughout Europe has impacted i) the probability that banks fall into a crisis regime and ii) the probability that banks stay in the crisis regime. The latter state is characterized by a high volatility and large positive returns of CDS spreads. Different regime-dependent indicators have been computed to assess heterogeneity within the region. The evidence indicates that the intensification of sovereign risk observed during the European debt crisis has positively and significantly driven the regime shifts in volatility of the bank CDS spreads due to increased risk aversion. The results show that the increase in sovereign credit risk seems to have generated second-round effects for some banks that have experienced a deterioration in their funding conditions due to a rise in the domestic sovereign default risk. Overall, our results suggest that sovereign CDS spreads can be considered good forewarning indicators for predicting the evolution of bank CDS spreads. We also find that the effects differ depending on the country and the financial institution. This result suggests that banks are heterogeneously exposed to sovereign credit risk within the same country. One argument relates to the size of these financial institutions and the domestic exposure to sovereign debt.

An alternative approach to predicting bank credit risk in Europe with Google data

The aim of this paper is to construct an alternative approach based on a sentiment index to measure bank credit risk in European countries using an alternative approach instead of traditional measures. Specifically, we use Google data for a set of keywords related to bank credit risk to capture investor sentiment. The resulting index shows a great similarity to traditional indexes based on bank CDS. The out-of-sample analysis demonstrates that our sentiment index is helpful for predicting bank credit risk during periods of financial distress, since it enhances the accuracy of the estimations.

Time to buy or just buying time? Lessons from October 2008 for the cross-border bailout of banks

This paper studies the country-level reaction of bank credit default swap (“CDS”) spreads and stock prices to bailout announcements in the US and five European countries in October 2008. Bailouts announcements are associated with bank CDS spreads narrowing, both for domestic and foreign banks, pointing to an important role for cross-border exposures. Movements in bank stock prices show mixed reactions, both domestically and cross-border, with banks receiving favorable government support outperforming foreign rivals. By January 2010, bank CDS spreads had stabilized at higher levels reflecting greater default risk, while bank stock prices remained significantly below their pre-crisis levels.

Do Information Contagion and Business Model Similarities Explain Bank Credit Risk Commonalities?

This paper revisits the credit spread puzzle in bank CDS spreads from the perspective of information contagion. The puzzle, first detected in corporate bonds, consists of two stylized facts: Structural determinants of credit risk not only have low explanatory power but also fail to capture common factors in the residuals (Collin-Dufresne et al., 2001). For the case of banks, we hypothesize that the puzzle exists because of omitted network effects. We therefore extend the structural models to account for information spillovers based on bank business model similarities. To capture this channel, we propose and construct a new intuitive measure for portfolio overlap using the complete asset holdings of the largest banks in the Eurozone. Incorporating the network information into the structural model for bank credit spreads increases explanatory power and removes a systemic common factor as well as a North-South common factor from the residuals. Furthermore, neglecting the network likely overstates the importance of structural determinants.

Sovereign - Bank Default Risk Linkages During the Greek Financial Crisis and the Role of the Italian Debt

The Greek crisis has brought to light the strong nexus between the credit risks of European banks and their sovereign. We study this phenomenon in Germany, France, Italy and Spain by estimating the conditional correlations between sovereign and bank CDS bond spreads over the period 2006-2015. Trivariate time-varying regime switching correlation analyses, such as the STCC-GARCH and DSTCC-GARCH, are implemented to associate causally the state shifts to the dynamics of the so-called “transition variables”. We find evidence of significant changes in the correlation structures due to the evolution of both the Greek and Italian crises.

Asset pricing factors and bank CDS spreads

This study compares the explanatory power of various asset pricing and macroeconomic risk factors in their ability to explain changes in the CDS spreads of global systemically important banks (G-SIBs). The factors include higher moment equity risks along with systematic sources of risk, such as investor uncertainty, interbank risk and foreign exchange volatility. For comparison, the five-factor asset pricing model by Fama and French (2017) is also implemented as a possible tool for explaining CDS spread changes. Estimation results from the quantile regression framework used herein show that heterogeneity in the explanatory power of the factors across low credit risk periods and high credit risk periods, such as during the 2008–09 financial crisis and 2011–13 European debt crisis, are a likely reason why extant time series regression models of CDS spreads yield instability in coefficient estimates and varying degrees of statistical significance across sample periods and time.

The Impact of Regulatory Stress Testing on Bank's Equity and CDS Performance

This paper investigates the impact of stress testing results on bank's equity and CDS performance using a large sample of twelve tests from the US CCAR and the European EBA regimes in the time period from 2010 to 2018. We find that passing banks experience positive abnormal equity returns and tighter CDS spreads, while failing banks show strong drops in equity prices and widening CDS spreads. We also document strong market reactions at the announcement date of the stress tests. Although the institutional designs between US and European stress tests differ, we generally observe similar capital market consequences for both regimes. We complement existing studies by investigating the predictability of stress test outcomes and evaluating strategic options for affected banks and investors.

Sovereign Bank Risk Interconnections During the Greek Financial Crisis and the Role of the Italian Debt

The Greek crisis has brought to light the strong nexus between the credit risks of European banks and their sovereign. We study this phenomenon in Germany, France, Italy and Spain by estimating the conditional correlations between sovereign and bank CDS bond spreads over the period 2006-2015. A trivariate time-varying regime switching correlation analysis, the STCC-GARCH, is implemented to associate the state shifts to the dynamics of the so-called “transition variable”. We start selecting as transition variable the first difference of the spread between Greek and German sovereign bond yields. We then expand the model – via a DSTCC-GARCH parameterization - and introduce a second transition variable, representing the influence of the Italian sovereign debt. There is a clear evidence of significant changes in the correlations structure due to the evolution of the Greek crisis and to the sustainability of the Italian debt, which in turns impinges on the tenability of the euro project. The role of Italy on the nexuses of France and Germany increases after 2011.

Do Information Contagion and Business Model Similarities Explain Bank Credit Risk Commonalities?

This paper revisits the credit spread puzzle in bank CDS spreads from the perspective of information contagion. The puzzle, first detected in corporate bonds, consists of two stylized facts: Structural determinants of credit risk not only have low explanatory power but also fail to capture common factors in the residuals (Collin-Dufresne et al., 2001). For the case of banks, we hypothesize that the puzzle exists because of omitted network effects. We therefore extend the structural models to account for information spillovers based on bank business model similarities. To capture this channel, we propose and construct a new intuitive measure for portfolio overlap using the complete asset holdings of the largest banks in the Eurozone. Incorporating the network information into the structural model for bank credit spreads increases explanatory power and removes a systemic common factor as well as a North-South common factor from the residuals. Furthermore, neglecting the network likely overstates the importance of structural determinants.

An international forensic perspective of the determinants of bank CDS spreads

Against the backdrop of the Great Recession, investigating the differences in institutional frameworks became important to explain the heterogeneity in the market perception about the credit quality and default risk of banks in different countries. Using data for 118 banks of 30 countries over the period 2004–2011, we find that an improvement of the quality of economic and legal institutions can help in reducing banks' CDS spreads, as banks operating in countries where the regulatory quality is stronger tend to be less affected by spikes in financial stress of 2008–2009. Considering a series of indicators of the financial structure of the banking system, our results reveal that more concentration of the banking sector, a stronger presence of foreign banks, a deterioration of the banking sector health or the lack of alternative means of finance is associated with higher CDS spreads of banks. We also show that the dynamics of bank CDS spreads accrue to: (i) the quality of banks’ balance sheet; (ii) (il)liquidity of banks’ assets; (iii) how profitable banks’ operations are; and (iv) the banks’ leverage ratios. Finally, higher CDS spreads of banks tend to be associated with periods of high inflation and low GDP growth.

Bank stability and refinancing operations during the crisis: Which way causality?

This paper explores the causality between refinancing operations of the ECB and the stability of the European banking sector during the recent crisis. We hypothesize that causality may run both ways. The ECB’s role in safeguarding the stability of the financial system suggests that refinancing operations may contribute to greater stability. Alternatively, instability in the banking sector may stimulate banks to tap liquidity at the ECB. Using country-level data on refinancing operations and bank CDS rates, we find a positive relationship between bank instability and liquidity uptake. High bank CDS rates are significantly related to the decision to tap liquidity, yet the liquidity uptake itself does little to bring these rates down quickly.