65 Pages Posted: 21 Jul 2010 Last revised: 13 Feb 2011
Date Written: 2009
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.
Keywords: distance to default, credit derivatives, credit default swap index, financial stability
JEL Classification: C32, G21, G33
Suggested Citation: Suggested Citation
Calice, Giovanni and Ioannidis, Christos and Williams, Julian M., Credit Derivatives and the Default Risk of Large Complex Financial Institutions (2009). Paolo Baffi Centre Research Paper No. 2009-75. Available at SSRN: https://ssrn.com/abstract=1645798 or http://dx.doi.org/10.2139/ssrn.1645798