Credit Risk Connectivity in the Financial Industry and Stabilization Effects of Government Bailouts

Abstract

Abstract:We identify the connections between financial institutions from different sectors of the financial industry based on joint extreme movements in credit default swap (CDS) spreads. First, we estimate pairwise co-crash probabilities (CCP) to identify significant connections among 193 international financial institutions and explain CCPs with shared country and/or sectoral origin indicators. Second, we use network centrality measures to identify systemically important financial institutions. Third, we test if bailouts stabilized network neighbors and thus this financial system. Financial firms from the same sector and country are most likely significantly connected. Inter-sector and intra-sector connectivity across countries also increase the likelihood of significant links. Central network indicators based on significant CCPs identify many institutions that failed during the 2007/2008 crisis. Excess equity returns in response to bank bailouts are overall negative and significantly lower for connected banks.Keywords: Extreme Value Theory, CDS Spreads, Systemic Institutions, Network Stability JEL-Classification: C14, G14, G 21, H12 Non-technical summaryThe failure of Lehman Brothers and the distress of AIG in September 2008 touched off a cascading series of financial shocks. These events were the catalyst of the global financial crisis and subsequently demonstrated that risks can propagate quickly in the financial industry both across countries and sectors. The set up of rescue schemes in numerous countries and a series of bailouts of distressed financial institutions signaled that any systemically important financial institution will be saved. While such policies potentially contributed to stabilize the financial system they bode ill for market discipline and moral hazard. This has led to calls for a centralized prudential regulator with a far reaching mandate to regulate systemic risks and discipline the management. Against this background, this paper contributes to the literature on financial stability by providing evidence on two important questions. First, which financial institutions are systemically relevant due to their connectivity? And secondly, how effective were national bailout policies in stabilizing the financial system? Methodologically, we approach these two questions using Extreme Value Theory to estimate so-called co-crash probabilities (CCP). CCPs measure the likelihood of an extreme joint deterioration in CDS spreads for pairs of financial institutions. We use daily CDS spreads of 193 financial intermediaries from eight different sectors and 37 different countries between January 2004 and January 2011 to estimate an overall number 18,528 bilateral connections. The focus on connections between individual intermediaries allows us to examining links between individual institutions allows us to obtain a network perspective, which is largely neglected in previous literature. To shed light on the first question, we use bootstrap methods to identify significant pair wise CCPs and investigate th...

Transatlantic systemic risk

“…First, we extend the broad body of literature on systemic risk for financial institutions. Studies that compare banks to other financial institutions (see, e.g., Billio et al, 2010;Bosma et al, 2012) mostly find that systemic risk is highest for banks. Very few studies (see, e.g., Harmon et al, 2010;Muns and Bijlsma, 2011;Buehler and Prokopczuk, 2010) compare systemic risk in the banking sector to systemic risk for non-financial firms, and come to the same conclusion: systemic risk is highest in the banking sector.…”

“…Multiple studies have explored this mechanism empirically, and come to the conclusion that adverse economic conditions coincide with higher systemic risk (see, e.g., Buehler and Prokopczuk, 2010;Bartram et al, 2007), and regions differ significantly regarding their susceptibility to contagion (Bae et al, 2003). In contrast, Bosma et al (2012) study global relations between financial firms, and find that systemic risk has uniformly decreased since the onset of the financial crisis. We contribute on this macro perspective by showing how the financial crisis has intensified systemic risk in the US and Europe.…”