Do Banks' Overnight Borrowing Rates Lead Their CDS Price? Evidence from the Eurosystem

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Title: Do Banks' Overnight Borrowing Rates Lead Their CDS Price? Evidence from the Eurosystem
Author: Tölö, Eero ; Jokivuolle, Esa ; Virén, Matti
Series: Journal of Financial Intermediation
Series volume: 31
Series number: July
Year of publication: 2017
Publication date: 25.5.2017
Page range: 93-106
Keywords: eurojärjestelmä; CDS; TARGET2; rahamarkkinat; korot; indikaattorit; pankit
JEL: G01; G14; G21
Other keywords: Private information; Money markets; Overnight borrowing rates; Credit default swaps (CDS); Lead-lag relationship; TARGET2; Eurosystem; Early-warning indicators
Abstract: We construct a measure of a bank's relative creditworthiness from the Eurosystem's proprietary inter-bank loan data: average overnight borrowing rate relative to an overnight rate index (AOR). We then investigate the dynamic relationship between AOR and the credit default swap price relative to the corresponding market index of 60 banks during 2008–2013. Price discovery mainly takes place in the CDS market, but AOR also contributes to it. The lagged daily changes of AOR help predict CDS. This indicates that AOR includes private information, which the CDS market does not immediately incorporate. We further show that the private information advantage is concentrated on days of market stress and on banks, which mainly borrow from relationship lender banks. Such borrower banks are typically smaller, have weaker ratings, and are likely to reside in crisis countries. Competent authorities can use AOR as a complementary indicator of banks’ concurrent health.

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