May 17, 2019

ESRB published a working paper on whether information contagion and business model similarities explain bank credit risk commonalities. The paper investigates whether incorporating business model similarities into the modeling of the credit spreads of the 22 largest banks in the Eurozone improves risk capture. The analysis reveals that similarities between bank business models constitute an important determinant of how markets value bank default risks.

The paper defines the baseline model and analyzes the credit spread puzzle in the Eurozone. It revisits the credit spread puzzle for banks from the perspective of information contagion. The paper includes the portfolio overlap measure as a proxy for bank similarities. The authors derive the Network Effects (NE) model and the Dynamic Network Effects (DNE) model as extensions to the structural regression model. Finally, the paper presents the empirical results for the NE and DNE models, respectively, before presenting the conclusions. The analysis reveals that similarities between bank business models constitute an important determinant of how markets value bank default risks. Market participants adjust their credit risk exposures to distressed banks using instruments such as credit default swaps (CDS). CDS price of a bank, therefore, reflects its default risk as it is perceived in the market. The study also finds that credit contagion and the credit spread puzzle are tightly connected. However, the results of the study highlight the need for more research on the network effects in credit risk. 

 

Related Link: Working Paper (PDF)

 

Keywords: Europe, EU, Banking, Credit Risk, CDS, Research, Credit Spread, Business Models, Default Risk, ESRB

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