Are CDS spreads a good proxy of bank risk? Evidence from the financial crisis

Based on a sample of mid-tier and top-tier internationally active banks with five-year senior CDS spreads, this paper investigates the determinants of CDS spreads and whether CDS spreads can be considered a good proxy of bank risk. The analysis encompasses three time periods: a pre-crisis period (1 January 2005 - 30 June 2007); a crisis period (1 July 2007 - 31 March 2009) and a crisis and its less acute phase period (1 July 2007 - 31 March 2010) and focuses exclusively on bank specific balance sheet ratios. The results of the empirical analysis indicate that bank CDS spreads, both in the pre-crisis period, but expecially in the crisis period (acute and less acute), reflect the risk captured by bank balance sheet ratios. We find that the determinants of bank CDS spreads vary strongly across time, as economic and financial conditions vary. TIER 1 ratio and leverage appear insignificant in all of the three periods considered, while liquidity indicators become significant only during and post crisis.