Bank Credit Spreads Research Articles

The impact of the ECB’s monetary policy on corporate borrowing costs

This paper examines the impact of the ECB’s monetary policy on corporate borrowing costs. We use an event study method to assess and compare the effects of both conventional and unconventional monetary policy on Germany and French corporate bond market (credit spreads). The sample of our research consists of daily data collected during the period from 04 January 1999 to 27 February 2015. This period spans the pre-crisis which begins when the ECB has launched the Economic and Monetary Union (EMU) and became responsible for the monetary policy in the euro area. We find significantly negative relation between conventional surprise and corporate credit spreads. Moreover, we find that a raise in German non-financial credit spreads and French credit spreads domestic in response to the SMP announcement. The OMT lowers the German non-financial credit spreads, while it raises German bank credit spreads and French corporate credit spreads both domestic and bund for two sectors. Finally, the LTROs are associated with a raise in corporate credit spreads. Our findings are confirmed in robustness checks by changing the non-standard monetary policy announcements with monetary policy event dummies used as one variable.

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.

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.

US Bank Credit Spreads During the Financial Crisis

This paper argues that first passage time models are likely to better than affine hazard rate models in modelling stressed credit markets and confirms their superior performance in explaining the behavior of Credit Default Swap rates for the major US banking groups over the period of the financial crisis. Affine models find it hard to deal with periods of exceptionally high or low default risk given their assumption of a constant rate of mean reversion in the hazard rate. In contrast, first passage time models are specified in terms of the distance to default rather than the hazard rate. The persistence of shocks varies with the distance to default, allowing the default curve to invert sharply (compress) when the distance to default is low (high). I use an empirical version of the Collin-Dufresne et al. (2003) model, which contains a smoothing parameter that allows it to control the relative effect of these shocks on the short spreads and can be interpreted as an information lag.

The Impact of Relative Seniority between Bank Debt and Deposit on Bank Credit Spreads under Stressful Conditions

Using a new structural model of credit risk based on the normal instead of the lognormal firm value dynamics and market price implied asset value volatility as the model volatility input, we quantify the value of credit spreads of the four largest U.S. banks had their senior unsecured bonds ranked pari-passu with bank deposits under the market conditions from 2006 to 2015. Since 1994 senior bank bonds are subordinated to bank deposits in the event of liquidation. And during the financial crises of 2008-2009 and 2011, the maximum 5-year bank credit spread among the four largest banks was over 400 basis points for the senior/subordinated bank capital structure, whereas the maximum 5-year bank credit spread would be slightly above 100 basis points under the same stressful conditions for the pro-rata bank capital structure, where senior bank bonds and deposits have equal seniority. Thus, the pro-rata bank capital structure will enhance both the ability of banks to serve as credit intermediaries during financial crisis and the overall resiliency of the financial system.

US bank credit spreads during the financial crisis

This paper argues that first passage time models are likely to better than affine hazard rate models in modelling stressed credit markets and confirms their superior performance in explaining the behavior of Credit Default Swap rates for the major US banking groups over the period of the financial crisis. Affine models find it hard to deal with periods of exceptionally high or low default risk given their assumption of a constant rate of mean reversion in the hazard rate. In contrast, first passage time models are specified in terms of the distance to default rather than the hazard rate. The persistence of shocks varies with the distance to default, allowing the default curve to invert sharply (compress) when the distance to default is low (high). I use an empirical version of the Collin-Dufresne et al. (2003) model, which contains a smoothing parameter that allows it to control the relative effect of these shocks on the short spreads and can be interpreted as an information lag.

Estimating the Deposit Insurance Premium from Bank CDS Spreads: An Application of the Structural Approach with a Normal Firm Value Diffusion Process

The new structural model of credit risk based on a normal firm value diffusion process can infer the firm value volatility from bank credit spreads that closely agreeing with the empirically estimated firm value volatility. We use the spread-implied firm value volatility as the model volatility input to predict the deposit insurance premium. For large U.S. banks from 2006 to 2015, the average spread-implied firm value volatility is approximately 22%, while the average model predicted deposit insurance premiums are 8 and 18 basis points per annum for 5- and 10-year deposit insurance contract maturity, respectively.

Time-Varying Dependence in Sovereign and Bank Credit Spreads: Evidence from Europe

This paper shows how a measure of bank-sovereign contagion can be extracted from CDS spreads using conditional Copula functions. I estimate the probability of a European bank to experience extreme upward co-movements in CDS spreads together with its home sovereign. Two main results are obtained. First, bank-sovereign contagion is shown to vary strongly over time and across countries. Contagion is higher when the sovereign suffers from poor public finances. Second, banks with higher exposures to their home sovereign disproportionately benefit from sovereign-bank contagion in that they exhibit significantly lower CDS spreads. The evidence is supportive of a private-to-public risk transfer.

Credit spread interdependencies of European states and banks during the financial crisis

We investigate the interdependence of the default risk of several Eurozone countries (France, Germany, Italy, Ireland, the Netherlands, Portugal, and Spain) and their domestic banks during the period between June 2007 and May 2010, using daily credit default swaps (CDS). Bank bailout programs changed the composition of both banks’ and sovereign balance sheets and, moreover, affected the linkage between the default risk of governments and their local banks. Our main findings suggest that in the period before bank bailouts the contagion disperses from bank credit spreads into the sovereign CDS market. After bailouts, a financial sector shock affects sovereign CDS spreads more strongly in the short run. However, the impact becomes insignificant in the long term. Furthermore, government CDS spreads become an important determinant of banks’ CDS series. The interdependence of government and bank credit risk is heterogeneous across countries, but homogeneous within the same country.

Contagion Effects between Sovereign and Bank Credit Spreads – A Global Analysis of Interdependencies between Sovereign and Bank CDS Spreads

The interdependencies of sovereign and banking sector credit spreads have been the subject of previous research. Since the 2007-2009 financial crisis the topic has an additional dimension as the size and structure of countries’ balance sheets have changed due to various financial sector bailouts. Moreover, the euro zone sovereign debt crisis exposed the relevance of inter-regional sovereign vs. banking sector risk as financial institutions around the globe appear to be affected by euro zone member solvency issues. In this paper, we examine the contagion effects between sovereign and bank CDS spreads on the inter- and intra-regional levels as well as on the intra-country level during four sub-periods between October 2005 and April 2011. Our results show that before the sovereign debt crisis period there are few inter-regional contagion effects between sovereign vs. bank default risk. By contrast, since the sovereign debt crisis period we observe significant dependencies between the regional sovereign CDS and the regional bank CDS in other regions, predominantly for the Asia-Pacific and European sovereign risk. Conversely, we also find that changes in certain regional bank CDS impact on the sovereign CDS in other regions since the financial crisis period. On the intra-regional level, we find that the impact of bank default risk on sovereign default risk increased substantially since the onset of the financial crisis which reflects the contingent liability of the state for the financial sector in its jurisdiction exposed during the financial crisis. The strength of this finding is highest for countries which provided substantial financial support to their banking sectors, namely America and the European countries. This finding is largely confirmed on the country level whereas interesting exceptions are observed also within groups of countries that share certain properties (such as countries affected by sovereign debt problems).

Credit Spread Interdependencies of European States and Banks During the Financial Crisis

We investigate the interdependence of the default risk of several Eurozone countries (France, Germany, Italy, Ireland, Netherlands, Portugal, and Spain) and their domestic banks during the period June 2007 - May 2010, using daily credit default swaps (CDS). Bank bailout programs changed the composition of both banks’ and sovereign balance sheets and, moreover, affected the linkage between the default risk of governments and their local banks. Our main findings suggest that in the period before bank bailouts the contagion disperses from bank credit spreads into the sovereign CDS market. After bailouts, a financial sector shock affects more strongly sovereign CDS spreads in the short-run, however, the impact becomes insignificant at a long horizon. Furthermore, government CDS spreads become an important determinant of banks’ CDS series. The interdependence of government and bank credit risk is heterogeneous across countries, but homogeneous within the same country.

Another Look at the Relation Between Credit Spreads and Interest Rates

Empirical research until now has mostly documented a negative relation between movements in interest rates and credit spreads. This negative relation is counterintuitive. But since it exists as a matter of fact, it has been widely utilized in testing theoretical models of default risk. Those models compatible with this negative relation, such as Merton9s model, are in turn recognized as the explanation for this originally surprising empirical result. In this article we suggest a way to break down AA bank credit spreads into 3 risk components: default risk, downgrade risk, and liquidity risk. Further analysis indicates that the liquidity risk layer is responsible for the negative correlation, while the default risk layer has a slightly positive correlation with interest rates. This result implies that using the whole credit spread in empirical studies to test default risk models may generally lead to incorrect conclusions. In addition, we provide a simple econometric model using on US market data for the liquidity risk layer which shows a more intuitive explanation of the apparent negative correlation. Finally, we also discuss the long-term behavior of interest rates and credit spreads, and suggest that there is no clear long-term relationship. <b>TOPICS:</b>Fixed income and structured finance, credit risk management, statistical methods

Bank Credit Rating Dynamics

An increase in the credit rating on the debt of an organisation is generally perceived positively, as higher credit ratings are, in the main, associated with lower perceived volatility in the market value of the assets of the entity that has issued debt. Lower asset volatility implies more stable and sustainable cash flows, and thus a lower likelihood of default on debt, and the result is a lower credit spread on the debt. If banks price their assets to realise a target return on economic capital, then a higher credit rating will result in higher loan rates if the fall in the bank's cost of capital, associated with the lower insolvency risk, is insufficient to offset the additional net income that the loan must be priced to cover. In this paper we develop a loan pricing model that assumes that financial institutions price their assets on a risk- and cost-adjusted basis and with the aim of achieving a minimum required return on the bank's economic capital holding. We compare theoretically derived decreases in the bank's cost of funds to actual data on bank credit spreads in order to ascertain the extent to which the increase in credit rating is beneficial to the bank. We find that the minimum decline in the cost of funds in our model generally exceeds the empirical data, meaning that the reduction in funding costs is insufficient to offset the increase on loan rates associated with higher economic capital. The divergence increases as the proportion of retail funds increases. We further find that the hurdle rate on economic capital is a significant factor in determining the value of a bank increasing its solvency standard. If the hurdle rate remains fixed regardless of the capital structure of the bank, then an upward movement in credit rating may have little impact on the value of the bank given the large divergence between the theoretical decline in the cost of wholesale funds and empirical data on bank credit spreads. However, the divergence is considerably less pronounced if the hurdle rate is varied in direct proportion to the leverage of the bank.

A Loan Pricing Model: The Influence of the Lender's Credit Rating

Within the context of a banking institution, economic capital is a statistical measure of the amount of resources required to meet unexpected losses over a specified time period and specified level of certainty. The amount of economic capital held by banks is thus a function of their target insolvency rate (the probability that losses will exceed a certain threshold) and is linked to an implied credit rating. In Australia, for example, the top four banks maintain sufficient economic capital to achieve a target credit rating of AA, which is equivalent to a 0.03% probability of insolvency. The benefits that accrue to banks from a high credit rating, in general, are access to lower cost funds in debt markets and low counterparty margins in swap and foreign exchange markets. However, as banks increase their economic capital to achieve a higher credit rating, the breakeven price on their asset portfolios will rise to the extent that the bank prices these assets to achieve a minimum return on economic capital. Ceteris paribus, the increase in loan rates may make the bank uncompetitive in specific asset markets, depending on the extent to which loan rates and other asset prices are market driven. Thus an increase in the solvency standard for a bank has two opposing effects on bank asset prices. To the extent that a bank prices its assets to achieve a target return on economic capital, an increase in economic capital will increase the net income that the bank needs to earn on its assets, resulting in higher asset prices. Offset against this, is the impact of a higher solvency standard on the cost of funds and market credit spreads for the bank. We propose that a bank that carries a large proportion of its funding book in retail funds may not benefit by targeting a high credit rating, depending on the sensitivity of retail depositors to incremental changes in credit rating. We model this relationship to ascertain an optimal economic capital requirement, varying the relative proportion of retail funds in the funding book. We compare the results of our model to empirical data on bank credit spreads in capital to markets to assess the extent to which an upgrade in the credit rating of a bank will be beneficial to the bank.