The Market-Implied Probability of Government Support for Distressed European Banks
23 Pages Posted: 12 Oct 2016 Last revised: 23 Dec 2019
Date Written: November 23, 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 Europe. These findings are supported by a measure of loss severity to senior bondholders and also a measure of government support based on a structural model.
Keywords: Bailout, bail-in, European Bank Resolution and Recovery Directive, credit default swaps
JEL Classification: G18, G13, G21
Suggested Citation: Suggested Citation