Bank Credit Default Swap Spreads Research Articles

ECB's unconventional monetary policy and spillover effects between sovereign and bank credit risk

PurposeThe paper examines the impact of the deteriorating fiscal conditions of Eurozone countries on spillover effects on bank credit margins. It is investigated whether these effects have been reduced after European Central Bank’s (ECB) signaling of pursuing an expansionary, unconventional, monetary policy to address the debt crisis in Eurozone.Design/methodology/approachA general econometric panel model is applied to investigate spillover effects between Eurozone countries and bank credit margins. In total, three periods are examined: the period before the peak of the global financial crisis and the beginning of the Irish banking crisis, the period during the debt and bank crisis in Eurozone and the period after ECB's signaling of extremely aggressive monetary easing.FindingsAccording to empirical results, before the peak of the global financial crisis there was no substantial credit risk transfer from Eurozone sovereigns to banks. During the period of debt and bank crisis in Eurozone, the deterioration of the fiscal situation of Eurozone countries had a significant impact on bank Credit Default Swap (CDS) spreads. After ECB's signaling of extremely aggressive monetary easing, it does not seem to be any significant relationship between Eurozone sovereigns and bank CDS spreads. These findings reinforce the assessment that ECB's measures were effective, achieving the key objective of normalizing economic conditions and ensuring financial stability in Eurozone.Research limitations/implicationsA question is whether effects can change when the corresponding contraction will lead to a reinstatement of “normal” conditions. Would there be a reversal of risk premium trends in bond markets? Although the answer from casual observations seems to be negative, it is a valid research question to be examined. An interesting issue concerning the unconventional monetary policy measures implemented by ECB concerns the issues of moral hazard that they incorporate, something that could not be addressed. Another research perspective could be the use of the beta coefficient to measure the systematic and unsystematic risk of banking sector shares.Practical implicationsThe results have strong implications for ECB and European banking regulation. Regulators should mainly pay more attention to the amount and concentration of sovereign debt held by banks. Eurozone financial system could be less vulnerable to the sovereign credit risk. It raised the critical question of whether a more strict regulation is needed. Regulators should not intervene if not necessary, but they must prevent the transmission of crises between markets. This will likely bring trust to the developed countries' sovereign debt and the portfolios of the financial institutions, which hold most of this debt will be considered safe as well.Social implicationsThe conclusions provide a safe counterweight in various respects. First, the negative effects and the need to rapidly cease or limit such policies. Second, the financial stability aimed by ECB. Such policies contain the possibility of a subsequent moral hazard related to Member State and bank behavior. However, these contingencies need to be assessed with the benefits resulting from the restoration of financial markets and the disconnection between banking and sovereign credit risk. This leads Eurozone's financial system to become less vulnerable to the sovereign credit risk and therefore more safe, helping to restore confidence in the real economy.Originality/valueContribution in terms of methodology and conclusions. It offers important conclusions regarding the limitations of yields and volatility of CDS spreads. It examines the spillover effects of the fiscal situation of Eurozone countries on banking institutions by extending the existing methodology and introducing new questions focusing on the reaction of CDS market to the ECB monetary policy, the reduction of risk premiums at sovereign and banking level and the gradual reduction of interdependence between them.

The transmission of default risk between banks and countries based on CAViaR models

This study investigates the relationship between country and bank credit default swap spreads by employing CAViaR models proposed by White et al.. By choosing a sample of six major European economies, we find that the bank default risk plays an important role in determining the country default risk in the Netherlands and Germany. By illustrating the time-varying VaRs, we find that the VaRs in these countries are significant from 2010 onward, showing a greater exposure to common shocks during the European debt crisis. Our results would be useful for investors and monetary authorities.

Utilizing News Topics for Credit Risk Management: The Explanation of Bank CDS Spreads

ABSTRACT Monitoring the default risk of banks is highly relevant for companies when they enter into derivative contracts with banks to hedge risks. These contracts are subject to the counterparty risk of the bank defaulting. In credit risk management, market-based measures such as credit default swap (CDS) spreads are used to continuously assess the credit risk of counterparties. At the same time, CDS spreads are difficult to interpret and explain. We investigate which financial news topics are positively or negatively related to bank CDS spreads. Our findings indicate that especially negative news topics are significantly associated with changes in CDS spreads. These include not only financial aspects such as a decrease in dividends or revenue guidance but also non-financial topics such as sanctions and legal issues. Thereby, our understanding of which topics addressed in financial news are relevant for supporting decision-making in the context of credit risk management is improved.

Determinants of European Bank Credit Default Swap Spreads

This paper analyzes the determinants of empirical credit default swap (CDS) spreads of European banks based on two different panel regression models. Previous studies primarily focus on non-financial firms. The Expected Default Frequency (EDF) is a statistically significant and economically important credit risk factor from the KMV structural model. The panel regression attributes more than 50% of the CDS spread variation to model-based EDF. Among bank-specific CAMELS indicators, a liquidity indicator and the return on assets are significant determinants. In addition to balance sheet ratios, the market-based EDF provides a substantial contribution to increasing the model’s explanatory power. Furthermore, the stock market index is an important market-wide indicator of the macroeconomic environment explaining European bank CDS spreads. This empirical study is the first finding an explanatory content of the EURIBOR-EUREPO, TED and five-year swap spread for CDS spread levels. With rising funding and liquidity risks or general risks to financial market stability, bank CDS spreads increase. Moreover, the EURIBOR-EUREPO and TED spread are able to increase the adjusted R-squared.

Empirical Credit Spread Components of Banks and their Coverage in Structural Models – An Integrated Analysis

During the global financial crisis and euro crisis, credit spreads of European banks have increased sharply, which has not only been attributed to default risk. Credit spreads can be estimated empirically or using structural models. In the KMV model, a firm defaults if the market value of assets falls below the Default Point (DP) based on liabilities. The Distance-to-Default (DD) measures how many standard deviations the asset value is away from DP. Based on DD, Moody's Analytics calculates a physical probability of default, the Expected Default Frequency (EDF). The paper analyzes the relation between the KMV structural model and empirical credit spread components. In addition to default risk, empirical credit default swap (CDS) spreads compensate risk-averse investors for liquidity risk and common spread risk. Default risk can generally be divided into a diffusion and jump component. Fundamental structural models cover default by a continuous decrease in the asset value below the default barrier, while unexpected jumps or (liquidity) shocks – such as bank runs – are not captured. Comparing model-based bank EDFs and empirical CDS-implied default probabilities, with a special focus on financial market and liquidity crises, the residual risks are derived. In contrast, previous studies primarily consider non-financial firms and phases of low financial market volatility. The present empirical study is the first integrated analysis of the determinants of one-year CDS spreads and the EDF of European banks from 2004 to mid-2015. Using a panel regression with time fixed effects, the residual impact on the logarithmized CDS-implied default probability, that cannot be explained by the logarithmized EDF, is decomposed into a systematic and idiosyncratic component. Since the global financial crisis and especially during the euro crisis, the EDF structural model assesses the default probabilities of European banks to be lower than the CDS market does – due to market-wide risks. The systematic residual impact increases substantially at the outbreak of both financial market and liquidity crises. At the onset of the global financial crisis and euro crisis, in particular market-wide liquidity risks imply a stronger increase in CDS spreads compared to EDFs. Combining market-based signals from European bank CDS spreads with model-based signals in an integrated analysis, the risk of a financial market crisis is derived. Market-wide indicators of funding and liquidity risk provide a statistically significant and economically important explanatory power for the systematic residual impact. Moreover, the risk premium is an essential determinant. Compared to alternative crisis indicators, the systematic residual impact achieves an equally good and during the euro crisis even better performance.

The European Bank Recovery and Resolution Directive: A market assessment

This paper provides evidence of the impact of the new European bank resolution regime on the sovereign-bank nexus. The implementation of the Bank Recovery and Resolution Directive (BRRD) is considered as an exogenous shock which provides the setting for a natural experiment. This investigation tests the financial markets’ perception of the effectiveness of the new rules in weakening the tight interconnectedness between sovereign and bank risk. A Difference-in-Differences (DiD) approach is adopted, building evidence from the Credit Default Swap (CDS) market for banks and non-financial corporates over the period 2011-18. The main findings do not indicate a significant weakening in the interaction between bank and sovereign CDS spreads, compared to the corresponding evidence for the non-financial corporate sector. An overall narrowing of the gap between bank and sovereign risk occurs, which initially implies a lack of credibility of the BRRD in financial markets. However, substantial cross-country variations are identified, particularly for Italy and non-euro area countries. These insights make a significant contribution to the policy debate on effective regulation of the sovereign-bank nexus, in the light of recent developments in the EU post-crisis reform agenda.

The single supervision mechanism and contagion between bank and sovereign risk

The objective of this article is to analyse how the Single Supervision Mechanism (SSM), the first pillar of the European Banking Union, affects contagion between bank and sovereign risk in the eurozone. Additionally, we test whether this contagion is transmitted from banks to sovereigns or vice versa, and how this transmission differs before and after the SSM. On the one hand, using quarterly data from 80 banks and 13 eurozone countries over the period 2009–2016 (2441 observations), we do not find solid evidence that the SSM reduces contagion from sovereign risk to banks’ stock returns. On the other hand, the analysis of credit default swap (CDS) spreads comprises quarterly data from 25 banks and 10 eurozone countries between 2009 and 2016 (771 observations). We find that the announcement of the SSM in March 2013 reduces contagion between bank and sovereign CDS spreads. Additionally, before the announcement of the SSM, an increase in sovereign risk does not alter contagion. However, after this announcement, an increase in sovereign risk leads to lower contagion. Therefore, the announcement of the SSM has an immediate effect on CDS spreads, while there is not enough evidence for banks’ stock returns.

Exports and bank shocks: Evidence from matched firm-bank data

A growing literature aims to understand the structural change and cyclical factors that contributed to the Great Trade Collapse. This paper adds to the conversation by investigating the impact of bank distress on firms’ exports using matched firm-bank data for the UK. We use two novel measures of bank distress: the Basel III net stable funding ratio, as well as the market-based bank credit default swap spreads, which best capture bank default risk, especially during crises. Our detailed database provides the crucial firm-bank relationship information that allows us to directly test for the banking channel effect on the real economy, and to carefully account for various endogeneities and biases in estimation. We also test for the possible contagion of the Sovereign Debt Crisis from the GIIPS economies to the UK. We find that the severe bank distress generated by the recent crises immediately, negatively and significantly affects UK firms’ exports, independent of demand shocks. Not all firms were impacted equally: private firms and firms in industries more dependent on external finance were impacted the most, while publicly owned firms were less affected by their bank’s distress.

The impact of expected regulatory changes: The case of banks following the 2016 U.S. election

We analyze bank stocks and credit default swap (CDS) spreads around the U.S. presidential election on November 8, 2016. We find a strong rally in bank stocks combined with an overall widening in bank CDS spreads during the days after the announcement of the election result. Following Donald Trump's victory, market participants appear to anticipate a lowering of financial sector regulation, particularly with respect to the Dodd-Frank act. In addition, we find that Global Systemically Important Banks (G-SIBs) reacted more positive than non-G-SIBs, with stocks having larger gains and CDS remaining relatively stable. Non-G-SIB stocks, on the other hand, gained less and their CDS widened, indicating less favorable changes from deregulation than for G-SIBs.

Sovereign and bank Interdependencies—Evidence from the CDS market

This paper investigates the bidirectional relationship between banking and sovereign debt crises. An extended model of Bolton and Jeanne (2011) with financial intermediaries and a government sector shows that sovereign default may induce a banking crisis as banks hold a large amount of government bonds. Nevertheless, a significant amount of outright bailouts or explicit bank guarantees may constrain the short-term liquidity of the government sector and trigger a sovereign debt crisis. Empirical analyses using the credit default swap (CDS) spreads of 11 European countries and 26 commercial banks from 2006 to 2012 support the theoretical findings. First, there was minimal comovement between bank and sovereign CDS spreads at the country level before the financial crisis. The correlation has increased significantly after the outbreak of the subprime crisis but notably dropped until the Greek debt crisis. Secondly, the same set of global risk factors could explain variations in both bank and sovereign CDS spreads after 2007 with higher sensitivity to the financial sector. Lastly, the study of price dynamics reveals that bank CDS spreads assumed the leading role prior to the Lehman Brothers bankruptcy but was gradually replaced by sovereign CDS spreads during the course of the Eurozone debt crisis. This suggests that investors have interpreted the sovereign credit risk as the main source of bank risk and traded sovereign CDS contracts to hedge financial risk. Bank guarantees and bailout programs prompted deteriorating fiscal conditions that ultimately led to a reverse spillover effect from the sovereign to the financial sector.

Determinants of bank CDS spreads in Europe

This paper empirically analyzes the determinants of credit default swap (CDS) spreads from a sample of 45 listed European banks over the 2004–2010 period. We use variables related to accounting- and market-based data, an indicator of liquidity in the CDS market and several variables from the macroeconomic environment in which these financial institutions operate. These variables are analyzed during both the pre-crisis period (2004–2007) and the crisis period (2008–2010). The primary conclusion is that the market variables have the greatest explanatory power. Additionally, we find that the explanatory power of the model is considerably higher during the crisis period than it is during the pre-crisis period.

The dynamics of spillover effects during the European sovereign debt turmoil

In this paper we modify and extend the framework of Diebold and Yilmaz (2011) to quantify spillovers between sovereign credit markets and banks in the euro area. Spillovers are estimated recursively from a vector autoregressive model of daily changes in credit default swap (CDS) spreads with exogenous common factors. We account for interdependencies between sovereign and bank CDS spreads and derive generalized impulse response functions. Specifically, we assess the systemic effect of an unexpected shock to the creditworthiness of a sovereign or country-specific bank index on other sovereigns and bank CDSs between October 2009 and July 2012. Channels of shock transmission from or to sovereigns and banks are summarized in a Contagion Index and its four components: (i) among sovereigns, (ii) among banks, (iii) from sovereigns to banks, and (iv) from banks to sovereigns. We also highlight the impact of policy-related events on the Contagion Index.

Determinants of European Bank CDS Spreads in Times of Crisis

This paper empirically analyzes the determinants of credit default swap (CDS) spreads from a sample of 45 listed European banks over the 2004-2010 period. We use variables related to accounting- and market-based data, an indicator of liquidity in the CDS market and several variables from the macroeconomic environment in which these financial institutions operate. These variables are analyzed during both the pre-crisis period (2004-2007) and the crisis period (2008-2010). The primary conclusion is that the market variables have the greatest explanatory power. Additionally, we find that the explanatory power of the model is considerably higher during the crisis period than it is during the pre-crisis period.

Determinants of bank credit default swap spreads: The role of the housing sector

This paper relates credit spreads (CDS prices) in the UK banking sector with the performance of the housing sector. Using data on banking sector CDS spreads for the period January 2004 to April 2011, we find that house price dynamics are a key driving factor behind the increase in credit spreads as reflected in CDS prices. Also we find that as stock prices increase, both bank capital and bank borrowing capacity increase that in turn decreases credit risk. Furthermore as banking sector liquidity increases banks tend to lend to less credit-worthy (subprime) borrowers that in turn increases credit risk in the banking sector. Collectively the results shed light on the determinants of credit risk in the banking sector.

How the Subprime Crisis went global: Evidence from bank credit default swap spreads

How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks' credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with short-term global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the pre-Lehman elevated levels – but now they more clearly reflected heightened funding and counterparty risk. After Lehman's failure, the prospect of global recession became imminent, auguring the further deterioration of banks' loan portfolios. At this point the entire global financial system had become infected.

How the Subprime Crisis Went Global: Evidence from Bank Credit Default Swap Spreads

How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal component analysis to identify common factors in the movement of banks’ credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with short-term global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the pre-Lehman elevated levels - but now they more clearly reflected heightened funding and counterparty risk. After Lehman’s failure, the prospect of global recession became imminent, auguring the further deterioration of banks’ loan portfolios. At this point the entire global financial system had become infected.

Are Banks Too Big to Fail or Too Big to Save? International Evidence from Equity Prices and CDS Spreads

Deteriorating public finances around the world raise doubts about countries'abilities to bail out their largest banks. For an international sample of banks, this paper investigates the impact of government indebtedness and deficits on bank stock prices and credit default swap spreads. Overall, bank stock prices reflect a negative capitalization of government debt and they respond negatively to deficits. The authors present evidence that in 2008 systemically large banks saw a reduction in their market valuation in countries running large fiscal deficits. Furthermore, the change in bank credit default swap spreads in 2008 relative to 2007 reflects countries'deterioration of public deficits. The results of the analysis suggest that some systemically important banks can increase their value by downsizing or splitting up, as they have become too big to save, potentially reversing the trend to ever larger banks. The paper also documents that a smaller proportion of banks are systemically important -- relative to gross domestic product -- in 2008 than in the two previous years, which could reflect private incentives to downsize.