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Story - antoq - 09/30/2010 - 06:49 - 0 comments - 0 attachments
The burgeoning market for sovereign credit default swaps (CDS) contracts offers a nearly unique window for viewing investors’ risk-neutral probabilities of major credit events impinging on sovereign issuers, and their risk-neutral losses of principal in the event of a restructuring or repudiation of external debts. In contrast to many “emerging market” sovereign bonds, sovereign CDS contracts are designed without complex guarantees or embedded options. Trading activity in the CDS contracts of several sovereign issuers has developed to the point that they are more liquid than many of the underlying bonds.
Moreover, in contrast to the corporate CDS market, where trading has been concentrated largely in the five-year maturity contract, there are actively traded CDS contracts at several maturity points between one and ten years. As such, a full term structure of CDS spreads is available for inferring default and recovery information from market data.
Global (exogenous) factors are increasingly seen as key determinants of the borrowing costs of emerging economies, and for good reason. In principle, the pricing of debt issued by financially integrated emerging economies should be no different from the pricing of non-investment grade securities in general, and low-grade bonds in developed economies in particular. Both should reflect the level of risk of the security, and a risk premium (the price of risk) that is, in turn, a reflection of the risk aversion—or alternatively, risk appetite—of international investors.
The provision and design of deposit insurance systems presents governments with an unprecedented set of challenges. Deposit insurance systems are typically motivated by a desire to decrease the risk of systemic bank runs (e.g., Diamond and Dybvig (1983)) and to protect small, uninformed depositors (e.g., Dewatripont and Tirole (1994)). Often, however, they are blamed for increasing the incentives of banks to take excessive risk by reducing, or even completely eliminating, the incentives of depositors to monitor and discipline their banks (e.g., Kane (1989) and Calomiris (1999)).
Market discipline by depositors is commonly understood as a situation in which depositors penalize riskier banks by requiring higher interest rates or by withdrawing their deposits (i.e., a leftward shift in the supply of deposits when bank risk increases). The main challenge policymakers are facing is how to design a deposit insurance scheme that protects the financial system from systemic bank runs without unduly reducing market discipline. To date, however, there is very little empirical evidence on the effects of implicit or explicit deposit insurance on market discipline, and there is even less evidence on how various design features of a deposit insurance scheme might affect market discipline. This paper investigates these questions in a natural experiment setting.
