Sovereign and bank CDS spreads: two sides of the same coin for European bank default predictability?

Avino, Davide and Cotter, John (2013): Sovereign and bank CDS spreads: two sides of the same coin for European bank default predictability?

Abstract

This paper investigates the relationship between sovereign and bank CDS spreads with reference to their ability to convey timely signals on the default risk of European sovereign countries and their banking systems. For a sample including six major European economies, we find that sovereign and bank CDS spreads are cointegrated variables at the country level. We then perform a more in-depth investigation of the underlying price discovery mechanisms, and find that both variables have an important price discovery role in the period preceding the financial crisis of 2007-2009. However, during the global financial crisis and the subsequent European sovereign debt crisis, sovereign CDS spreads dominate the price discovery process. Our findings strongly suggest that, especially during crisis periods, sovereign CDS spreads incorporate more timely information on the default probability of European banks than their corresponding bank CDS spreads. Price discovery measures based on CDS prices could be used as market triggers to increase equity levels at financial institutions and in the various forms of contingent capital

• Item Type: MPRA Paper
• Language: English
• Keywords: Credit default swap spreads; price discovery; information flow; financial crisis; banks; sovereign risk; bank capital; contingent capital
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty; G - Financial Economics > G0 - General > G01 - Financial Crises; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G2 - Financial Institutions and Services > G20 - General

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