Determinants of European Bank Credit Default Swap Spreads

Abstract

This paper analyzes the determinants of empirical credit default swap (CDS) spreads of European banks based on two different panel regression models. Previous studies primarily focus on non-financial firms. The Expected Default Frequency (EDF) is a statistically significant and economically important credit risk factor from the KMV structural model. The panel regression attributes more than 50% of the CDS spread variation to model-based EDF. Among bank-specific CAMELS indicators, a liquidity indicator and the return on assets are significant determinants. In addition to balance sheet ratios, the market-based EDF provides a substantial contribution to increasing the model’s explanatory power. Furthermore, the stock market index is an important market-wide indicator of the macroeconomic environment explaining European bank CDS spreads. This empirical study is the first finding an explanatory content of the EURIBOR-EUREPO, TED and five-year swap spread for CDS spread levels. With rising funding and liquidity risks or general risks to financial market stability, bank CDS spreads increase. Moreover, the EURIBOR-EUREPO and TED spread are able to increase the adjusted R-squared.

Keywords: Credit Default Swap Spread, Expected Default Frequency, CAMELS Indicators, Market Risk, European Banks

JEL Classification: G13, G21, G32, M41