CDX and iTraxx and their relation to the systemically important financial institutions: Evidence from the 2008-2009 financial crisis

This paper empirically investigates the linkages between the CDS index market and the equity returns of a sample of systemically important financial institutions (SIFIs). Both the 5- year investment grade iTraxx Europe and the 5-year investment grade CDX North America indexes are adopted as a market consensus of the overall credit risk in the financial system. Through a multivariate VAR model using historical data, the investigation uncovers three key findings. First, the equity returns for all systematically important institutions are inversely associated to shocks in the CDS index market. Second, European institutions demonstrate a stronger connection with the iTraxx whilst the US institutions are more closely related to the CDX. Furthermore, volatility originating in the CDS index market is unambiguously transmitted to both the insurance and the banking sector. Third, US banks are most severely distressed by the volatility transmission mechanism whilst European insurers are least affected

Credit Derivatives and the Default Risk of Large Complex Financial Institutions

This paper addresses the impact of developments in the credit risk transfer market on the viability of a group of systemically important financial institutions. We propose a bank default risk model, in the vein of the classic Merton-type, which utilizes a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the global credit environment. In the first step, we establish the existence of significant detrimental volatility spillovers from the CDS market to the banks’ equity prices, suggesting a credit shock propagation channel which results in serious deterioration of the valuation of banks’ assets. In the second step, we show that substantial capital injections are required to restore the stability of the banking system to an acceptable level after shocks to the CDX and iTraxx indices. Our empirical evidence thus informs the relevant regulatory authorities on the magnitude of banking systemic risk jointly posed by CDS markets.distance of default, credit derivatives, credit default swap index, financial stability

The effects of the EBA's stress testing framework on banks' lending

This paper investigates the impact of the European Banking Authority (EBA)'s supervisory stress tests on bank lending. Using a sample of 282 European banks over the period 2006–2018, we find that stress-tested banks experience higher credit risk and reduce lending for specific loan types. In particular, due to country heterogeneities, we find that the contraction in lending is more pronounced for stress-tested banks in the GIIPS region. Our results also suggest that the elevated credit risk of highly-exposed stress-tested banks can be a driving factor of a reduction in bank lending. Consequently, prudential measures requiring banks to hold higher capital buffers are justified to contain credit risk shocks

Contingent convertible bonds in financial networks

We study the role of contingent convertible bonds (CoCos) in a complex network of interconnected banks. By studying the system’s phase transitions, we reveal that the structure of the interbank network is of fundamental importance for the effectiveness of CoCos as a financial stability enhancing mechanism. Our results show that, under some network structures, the presence of CoCos can increase (and not reduce) financial fragility, because of the occurring of unneeded triggers and consequential suboptimal conversions that damage CoCos investors. We also demonstrate that, in the presence of a moderate financial shock, lightly interconnected financial networks are more robust than highly interconnected networks. This makes them a potentially optimal choice for both CoCos issuers and buyers

A Markov switching unobserved component analysis of the CDX index term premium

Using a Markov switching unobserved component model we decompose the term premium of the North American CDX index into a permanent and a stationary component. We establish that the inversion of the CDX term premium is induced by sudden changes in the unobserved stationary component, which represents the evolution of the fundamentals underpinning the probability of default in the economy. We find evidence that the monetary policy response from the Fed during the crisis period was effective in reducing the volatility of the term premium. We also show that equity returns make a substantial contribution to the term premium over the entire sample period

Liquidity spillovers in sovereign bond and CDS markets: an analysis of the Eurozone sovereign debt crisis

At the end of 2009, countries in the Eurozone (euro area) began to experience a sudden divergence of bond yields as the market perception of sovereign default risk increased. The theory of complete markets suggests that sovereign debt and credit default swap (CDS) credit spreads should track each other closely. In addition, liquidity risk should be priced into both instruments in such a way that buying exposure to the same default risk is identically priced. We use a time-varying vector autoregression framework to establish the credit and liquidity spread interactions over the 2009-2010 crisis period. We find substantial variation in the patterns of the transmission effect between maturities and across countries. Our major result is that, for several countries, including Greece, Ireland and Portugal the liquidity of the sovereign CDS market has a substantial time varying influence on sovereign bond credit spreads. This evidence is of particular importance in the current policy context. © 2011 Elsevier B.V

Credit derivatives and the default risk of large complex financial institutions

This paper proposes and implements a multivariate model of the coevolution of the first and second moments of two broad credit default swap indices and the equity prices of sixteen large complex financial institutions. We use this empirical model to build a bank default risk model, in the vein of the classic Merton-type, which utilises a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the conditions of the global credit environment. In the first step, we estimate the dynamic correlations and volatilities describing the evolution of the CDS indices and the banks’ equity prices and then impute the implied assets and their volatilities conditional on the evolution and volatility of equity. In the second step, we show that there is a substantial ‘asset shortfall’ and that substantial capital injections and/or asset insurance are required to restore the stability of our sample institutions to an acceptable level following large shocks to the aggregate level of credit risk in financial markets

Liquidity spillovers in sovereign bond and CDS markets

Abstract At the end of 2009, countries in the Eurozone (euro area) began to experience a sudden divergence of bond yields as the market perception of sovereign default risk increased. The theory of complete markets suggests that sovereign debt and credit default swap (CDS) credit spreads should track each other closely. In addition, liquidity risk should be priced into both instruments in such a way that buying exposure to the same default risk is identically priced. We use a time-varying vector autoregression framework to establish the credit and liquidity spreads interactions over the 2009-2010 crisis period. We find substantial variation in the patterns of the transmission effect between maturities and across countries. Our major result is that for several countries, including Greece, Ireland and Portugal the liquidity of the sovereign CDS market has a substantial time varying influence on sovereign bond credit spreads. This evidence is of particular importance in the current policy context

Short-term determinants of the idiosyncratic sovereign risk premium: a regime-dependent analysis for European credit default swaps

This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility