The Market-Implied Probability of Government Support for Distressed European Banks
20 Pages Posted: 12 Oct 2016 Last revised: 13 Mar 2018
Date Written: March 9, 2018
Exploiting a 2014 change in credit default swap (CDS) contracts on European banks, we introduce a measure of market expectation of European government support for distressed banks. CDS contract terms were changed to cover losses from “government intervention” and related bail-in events. For many large European banks, subordinated CDS spreads are available under both the old and new contract terms; the difference (or basis) between the two spreads measures the market price of protection against losses from certain government actions that have mainly imposed losses on subordinated debt holders but left senior debt unscathed. Relative to the level of CDS spreads, the basis initially declined in 2014, a trend we associate with the adoption of European bank resolution reforms and bail-in requirements. This trend reversed in 2016, with growing prospects for bank bailouts in Italy. Even with an increase in the relative basis, CDS spreads signal a market perception that banks have insufficient subordinated debt to fully protect senior bondholders in case of default.
Keywords: Credit Default Swaps, Banks, Government Intervention, European Bank Resolution
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