The Fundamental Determinants of Credit Default Risk for European Large Complex Financial Institutions
IMF Working Papers, June 1, 2010
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- The Fundamental Determinants of Credit Default Risk for European Large Complex Financial Institutions
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Bibliographic details
- Authors: Jiri Podpiera, Inci Ötker
- Published: June 1, 2010
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781455201365.001
Summary findings
- The paper identifies fundamental variables that drive credit default swaps during the initial phase of distress in selected European Large Complex Financial Institutions (LCFIs).
- The results indicate that LCFIs’ business models, earnings potential, and economic uncertainty are among the most significant determinants of credit risk.
- Economic uncertainty is represented by market expectations about the future risks of a particular LCFI and market views on prospects for economic growth.
- The findings are broadly consistent with literature on bank failure, encompassing the CAMELS structure: Capital Adequacy, Asset Quality, Management Quality, Earnings Potential, Liquidity, and Sensitivity to Market Risk.
- By linking financial and market fundamentals of LCFIs to their CDS spreads, the paper proposes a potential tool for fundamentals-based vulnerability assessment and an early warning system for LCFIs.
Methodology and data
- Data frequency and coverage:
- Yearly data over 2004 - 08.
- Sample: 29 European LCFIs.
- Estimation approach:
- Uses a dynamic panel data estimator to identify determinants of CDS spreads during initial distress.
Key determinants of CDS spreads (as reported)
- Business models of LCFIs.
- Earnings potential.
- Economic uncertainty, proxied by:
- Market expectations about the future risks of a particular LCFI.
- Market views on prospects for economic growth.
- Consistency with CAMELS framework:
- Capital Adequacy.
- Asset Quality.
- Management Quality.
- Earnings Potential.
- Liquidity.
- Sensitivity to Market Risk.
Implications and policy recommendations
- Fundamentals-based monitoring:
- Linking financial and market fundamentals to CDS spreads provides a potential tool for vulnerability assessment.
- Can serve as an early warning system for LCFIs in the initial phase of distress.
- Use for supervisors and market participants:
- Monitoring business models, earnings potential, and measures of economic uncertainty can improve detection of elevated credit default risk among LCFIs.