The Market-Implied Probability of European Government Intervention in Distressed Banks
34 Pages Posted: 12 Oct 2016 Last revised: 10 Dec 2016
Date Written: December 9, 2016
New contract terms for credit default swaps (CDS) on banks were introduced in 2014 to cover losses from government intervention and related bail-in events. For many large European banks, 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 to resolve distressed banks. We investigate cross-sectional and time series properties of this basis, relative to each bank’s CDS spread. We interpret a general decline in the relative basis as a market price-based signal that governments are less likely to bailout banks in distress, but that banks do not yet have sufficient bail-in debt to protect senior bond holders in case of a credit event.
Keywords: Credit Default Swaps, Banks, Government Intervention, European Bank Resolution
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