When Senior Meets Junior: Information in Credit Default Swap Spreads of Large Banks

38 Pages Posted: 2 Mar 2010 Last revised: 24 Jul 2012

See all articles by Lars Norden

Lars Norden

Getulio Vargas Foundation (FGV) - Brazilian School of Public and Business Administration (EBAPE); Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finanças

Martin Weber

University of Mannheim - Department of Banking and Finance

Date Written: July 24, 2012

Abstract

We investigate whether information in credit default swap spreads (CDS) is useful for assessing the default risk of large banks. Because of banks’ special capital structure two liquid trading segments have emerged: one for CDS on senior bank debt, and one for CDS on subordinate bank debt. Analyzing a sample of frequently traded large European banks during the period 2001-2008 we find that both CDS spreads contribute significantly to price discovery but transactions costs (i.e., the relative bid-ask spread) are lower in subordinate CDS. After the beginning of the financial crisis there is a lead-lag relation between senior and subordinate CDS, and subordinate CDS loose their transaction cost advantage. Furthermore, the loss given default on senior bank debt increases from 57% before the crisis to 62% during the crisis and the probability of default increases from 0.32% to 1.23%. Our results indicate that the CDS market conveys differentiated information on banks’ default risk that is suited to play an important role in enhancing market discipline in a future supervisory and regulatory framework.

Keywords: Credit derivatives, Banks, Financial crisis, Subordinate debt, Price discovery, Loss given default

JEL Classification: G10, G20, G21

Suggested Citation

Norden, Lars and Weber, Martin, When Senior Meets Junior: Information in Credit Default Swap Spreads of Large Banks (July 24, 2012). Available at SSRN: https://ssrn.com/abstract=1561729 or http://dx.doi.org/10.2139/ssrn.1561729

Lars Norden (Contact Author)

Getulio Vargas Foundation (FGV) - Brazilian School of Public and Business Administration (EBAPE) ( email )

Rua Jornalista Orlando Dantas 30
Rio de Janeiro, 22231-010
Brazil
+552130832431 (Phone)

HOME PAGE: http://www.larsnorden.de

Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finanças ( email )

Praia de Botafogo 190/1125, CEP
Rio de Janeiro RJ 22253-900
Brazil

Martin Weber

University of Mannheim - Department of Banking and Finance ( email )

D-68131 Mannheim
Germany
+49 621 181 1532 (Phone)
+49 621 181 1534 (Fax)

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