Friday, March 12, 2010

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

By Lars Norden and Martin Weber

Abstract: We investigate whether price information from credit default swap (CDS) markets is useful for assessing the default risk of large banks during 2001-2008. We exploit the fact that there are two liquid trading segments for banks as underlyings: one for CDS on senior bank debt, and one for CDS on subordinate bank debt. Using both CDS spreads for the same bank makes it possible for us to derive daily market-implied values for two risk parameters jointly. Comparing an international sample in the pre- and post-crisis period, we show that the loss given default on senior bank debt increases from 56% to 61% and the probability of default increases from 0.34% to 1.22%. We also find that both CDS spreads contribute significantly to price discovery but transactions costs, as measured by the relative bid-ask spread, are lower in subordinate CDS. After the beginning of the financial crisis, we find a lead-lag relation between senior and subordinate CDS, and subordinate CDS loose their transaction cost advantage. Our results highlight that CDS markets convey differentiated information on banks’ default risk that is suited to play an important role in enhancing market discipline.

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