Recent years have been disastrous for financial institutions because of sharp and abrupt asset price declines, liquidity dry-ups, and fear for chain risk transfers of counterparty risks. This paper presents examination of the transmission mechanism of the global financial crisis onto credit default swap (CDS) spreads of major financial institutions including commercial banks, investment banks, and insurance companies. Special attention is devoted to the effect of common factors on the CDS spreads as well as their interdependence.
During the global financial crisis, we observed CDS spreads skyrocket, which can be explained only slightly by changes in the probability of default. That soaring of the CDS spreads should reflect changes in market participants’ attitude related to risks as well as their perception of uncertainty in future macroeconomic conditions. Gai and Vause (2006) argue that risk premia must depend not only on the riskiness of assets but also on the degree to which investors accept uncertainty (risk aversion) and the level of uncertainty itself (uncertainty about macroeconomic prospects). The Bank of Japan (2008b) also asserts that a market participant’s attitude related to risk can further depend on liquidity constraints; financial institutions under severe liquidity constraints are unwilling to bear risk. Funding liquidity and uncertainty in the macroeconomic environment are therefore likely to affect CDS spreads as common factors.
A CDS is a bilateral contract between the buyer and seller of protection. Its price is presumably determined reflecting conditions affecting their behaviors. When the seller of protection is facing a liquidity constraint, the seller might raise the CDS spread even though the solvency of a reference entity does not increase. The tighter the liquidity, the more the seller might require a risk premium for bearing fundraising risk. The seller, who has a pessimistic expectation about future macroeconomic conditions, is also likely to raise the spread.
Bankruptcy scenarios for financial institutions include two types: insolvency because of excessive debt, and bankruptcy caused by fundraising difficulties. Therefore, the abrupt hike of CDS spreads of financial institutions during the midst of the global turmoil, especially those that had used highly leveraged, short-term financing, might also be a result of market participants’ assessment of the probability of bankruptcy. In fact, investors can buy and sell protection without owning any debt of the reference entity. In a case in which investors who do not own the underlying debt rush into speculation on bankruptcy of the reference entity which is on the verge of bankruptcy because of a liquidity squeeze, and sellers of protection, on the other hand, evaporate for fear of loss, its CDS spread presumably soars sharply.
A reverse transmission might also exist. During the global financial crisis, financial institutions raised their doubts and fears of one another in the interbank market, triggering a sharp rise in the interbank interest rate. Under such circumstances, the rise in the CDS spread of financial institutions, particularly those that had used highly leveraged, short-term financing, was likely to further deteriorate the credit tightening.
