The Market-Implied Probability of Government Support for Distressed European Banks

20 Pages Posted: 12 Oct 2016 Last revised: 13 Mar 2018

Richard Neuberg

Columbia University - Department of Statistics

Paul Glasserman

Columbia Business School

Benjamin Kay

Board of Governors of the Federal Reserve System

Sriram Rajan

Government of the United States of America - Office of Financial Research

Date Written: March 9, 2018

Abstract

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

Suggested Citation

Neuberg, Richard and Glasserman, Paul and Kay, Benjamin and Rajan, Sriram, The Market-Implied Probability of Government Support for Distressed European Banks (March 9, 2018). OFR WP 16-10; Columbia Business School Research Paper No. 16-73. Available at SSRN: https://ssrn.com/abstract=2851177 or http://dx.doi.org/10.2139/ssrn.2851177

Richard Neuberg (Contact Author)

Columbia University - Department of Statistics ( email )

Mail Code 4403
New York, NY 10027
United States

Paul Glasserman

Columbia Business School ( email )

3022 Broadway
403 Uris Hall
New York, NY 10027
United States
212-854-4102 (Phone)
212-316-9180 (Fax)

Benjamin Kay

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

HOME PAGE: http://https://www.federalreserve.gov/econres/benjamin-s-kay.htm

Sriram Rajan

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

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