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Analyzing Default Risk and Liquidity Demand during a Financial Crisis: The Case of Canada

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Author Info

  • Jason Allen
  • Ali Hortaçsu
  • Jakub Kastl

Abstract

This paper explores the reliability of using prices of credit default swap contracts (CDS) as indicators of default probabilities during the 2007/2008 financial crisis. We use data from the Canadian financial system to show that these publicly available risk measures, while indicative of initial problems of the financial system as a whole, do not seem to correspond to risks implied by the cross-sectional heterogeneity in bank behavior in short-term lending markets. Strategies in, and reliance on the payments system as well as special liquidity-supplying tools provided by the central bank seem to be more important additional indicators of distress of individual banks, or lack thereof than the CDSs. It therefore seems that central banks should utilize high-frequency data on liquidity demand to obtain a better picture of financial health of individual participants of the financial system.

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File URL: http://www.bankofcanada.ca/wp-content/uploads/2011/08/wp2011-17.pdf
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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 11-17.

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Length: 39 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:bca:bocawp:11-17

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Keywords: Financial Institutions; Financial markets; Payment; clearing; and settlement systems;

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References

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  1. John B. Taylor & John C. Williams, 2009. "A black swan in the money market," Proceedings, Federal Reserve Bank of San Francisco, issue Jan.
  2. Ali Hortacsu & Jakub Kastl, 2010. "Informational Advantage and Information Structure: An Analysis of Canadian Treasury Auctions," Discussion Papers 09-031, Stanford Institute for Economic Policy Research.
  3. Acharya, Viral V & Merrouche, Ouarda, 2012. "Precautionary hoarding of liquidity and inter-bank markets: Evidence from the sub-prime crisis," CEPR Discussion Papers 8859, C.E.P.R. Discussion Papers.
  4. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed not Frozen: The Fed Funds Market in the Financial Crisis," NBER Working Papers 15806, National Bureau of Economic Research, Inc.
  5. Acharya, Viral V & Schnabl, Philipp & Suarez, Gustavo, 2012. "Securitization Without Risk Transfer," CEPR Discussion Papers 8769, C.E.P.R. Discussion Papers.
  6. James Chapman & Jonathan Chiu & Miguel Molico, 2013. "A Model of Tiered Settlement Networks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(2-3), pages 327-347, 03.
  7. Nuno Cassola & Ali Hortacsu & Jakub Kastl, 2009. "The 2007 Subprime Market Crisis Through the Lens of European Central Bank Auctions for Short-Term Funds," NBER Working Papers 15158, National Bureau of Economic Research, Inc.
  8. Eisenschmidt, Jens & Hirsch, Astrid & Linzert, Tobias, 2009. "Bidding behaviour in the ECB’s main refinancing operations during the financial crisis," Working Paper Series 1052, European Central Bank.
  9. Stéphane Lavoie & Alex Sebastian & Virginie Traclet, 2011. "Lessons from the Use of Extraordinary Central Bank Liquidity Facilities," Bank of Canada Review, Bank of Canada, vol. 2011(Spring), pages 27-36.
  10. Paolo Angelini & Andrea Nobili & Cristina Picillo, 2011. "The Interbank Market after August 2007: What Has Changed, and Why?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(5), pages 923-958, 08.
  11. Johannes C. Stroebel & John B. Taylor, 2009. "Estimated Impact of the Fed’s Mortgage-Backed Securities Purchase Program," NBER Working Papers 15626, National Bureau of Economic Research, Inc.
  12. Gara Afonso & Anna Kovner & Antoinette Schoar, 2011. "Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis," Journal of Finance, American Finance Association, vol. 66(4), pages 1109-1139, 08.
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Citations

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Cited by:
  1. Georges Dionne & Olfa Maalaoui Chun, 2013. "Default and liquidity regimes in the bond market during the 2002-2012 period," Canadian Journal of Economics, Canadian Economics Association, vol. 46(4), pages 1160-1195, November.
  2. Olivier Armantier & Adam Copeland, 2012. "Assessing the quality of “Furfine-based” algorithms," Staff Reports 575, Federal Reserve Bank of New York.
  3. Anna Kovner & David Skeie, 2013. "Evaluating the quality of fed funds lending estimates produced from Fedwire payments data," Staff Reports 629, Federal Reserve Bank of New York.

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