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The Fundamental Determinants of Credit Default Risk for European Large Complex Financial Institutions

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  • Jiri Podpiera
  • Inci Ötker

Abstract

This paper attempts to identify the fundamental variables that drive the credit default swaps during the initial phase of distress in selected European Large Complex Financial Institutions (LCFIs). It uses yearly data over 2004 - 08 for 29 European LCFIs. The results from a dynamic panel data estimator show that LCFIs’ business models, earnings potential, and economic uncertainty (represented by market expectations about the future risks of a particular LCFI and market views on prospects for economic growth) are among the most significant determinants of credit risk. The findings of the paper are broadly consistent with those of the literature on bank failure, where the determinants of the latter include the entire CAMELS structure - that is, Capital Adequacy, Asset Quality, Management Quality, Earnings Potential, Liquidity, and Sensitivity to Market Risk. By establishing a link between the financial and market fundamentals of LCFIs and their CDS spreads, the paper offers a potential tool for fundamentals-based vulnerability and early warning system for LCFIs.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 10/153.

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Length: 31
Date of creation: 01 Jun 2010
Date of revision:
Handle: RePEc:imf:imfwpa:10/153

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Related research

Keywords: Financial institutions; Europe; Banks; Credit risk; Economic models; bond; autocorrelation; corporate bond; statistics; standard errors; finite sample; stock market; bonds; corporate bonds; probability; probabilities; heteroscedasticity; standard deviation; explanatory power; significance level; stock market volatility; bond spreads; equation; financial statements; equity capital; financial markets; significance levels; random walk; stock returns; surveys; financial stability; stock market index; random walk process; futures markets; risk-free interest rate; credit derivatives; bond yield; government bonds; samples; statistical inference; dummy variable; estimation period; money market rate; missing data; estimation of equation; econometrics; descriptive statistics; covariance; bond yields; equations; sample bias; parsimonious model; hypothesis testing; future value;

This paper has been announced in the following NEP Reports:

References

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  1. Roberto Blanco & Simon Brennan & Ian W Marsh, 2004. "An empirical analysis of the dynamic relationship between investment-grade bonds and credit default swaps," Bank of England working papers 211, Bank of England.
  2. Avramov, Doron & Chordia, Tarun & Jostova, Gergana & Philipov, Alexander, 2009. "Credit ratings and the cross-section of stock returns," Journal of Financial Markets, Elsevier, vol. 12(3), pages 469-499, August.
  3. Koetter, Michael & Kick, Thomas, 2007. "Slippery slopes of stress: ordered failure events in German banking," Discussion Paper Series 2: Banking and Financial Studies 2007,03, Deutsche Bundesbank, Research Centre.
  4. Cremers, Martijn & Driessen, Joost & Maenhout, Pascal & Weinbaum, David, 2008. "Individual stock-option prices and credit spreads," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2706-2715, December.
  5. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, vol. 53(6), pages 2225-2241, December.
  6. Fabozzi, Frank J. & Cheng, Xiaolin & Chen, Ren-Raw, 2007. "Exploring the components of credit risk in credit default swaps," Finance Research Letters, Elsevier, vol. 4(1), pages 10-18, March.
  7. Tang, Dragon Yongjun & Yan, Hong, 2008. "Market conditions, default risk and credit spreads," Discussion Paper Series 2: Banking and Financial Studies 2008,08, Deutsche Bundesbank, Research Centre.
  8. Windmeijer, Frank, 2005. "A finite sample correction for the variance of linear efficient two-step GMM estimators," Journal of Econometrics, Elsevier, vol. 126(1), pages 25-51, May.
  9. Tigran Poghosyan & Martin Cihák, 2009. "Distress in European Banks," IMF Working Papers 09/9, International Monetary Fund.
  10. Jan Ericsson & Kris Jacobs & Rodolfo A. Oviedo, 2004. "The Determinants of Credit Default Swap Premia," CIRANO Working Papers 2004s-55, CIRANO.
  11. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
  12. James B. Thomson, 2009. "On systemically important financial institutions and progressive systemic mitigation," Policy Discussion Papers, Federal Reserve Bank of Cleveland, issue Aug.
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