When Senior Meets Junior: Information in Credit Default Swap Spreads of Large Banks
38 Pages Posted: 2 Mar 2010 Last revised: 24 Jul 2012
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: Suggested Citation