Persistence of Bank Credit Default Swap Spreads

Abstract

Credit default swap (CDS) spreads measure the default risk of the reference entity and have been frequently used in recent empirical papers. To provide a rigorous econometrics foundation for empirical CDS analysis, this paper applies the augmented Dickey–Fuller, Phillips–Perron, Kwiatkowski–Phillips–Schmidt–Shin, and Ng–Perron tests to study the unit root property of CDS spreads, and it uses the Phillips–Ouliaris–Hansen tests to determine whether they are cointegrated. The empirical sample consists of daily CDS spreads of the six large U.S. banks from 2001 to 2018. The main findings are that it is log, not raw, CDS spreads that are unit root processes, and that log CDS spreads are cointegrated. These findings imply that, even though the risks of individual banks may deviate from each other in the short run, there is a long-run relation that ties them together. As these CDS spreads are an important input for financial systemic risk, there are at least two policy implications. First, in monitoring systemic risk, policymakers should focus on long-run trends rather than short-run fluctuations of CDS spreads. Second, in controlling systemic risk, policy measures that reduce the long-run risks of individual banks, such as stress testing and capital buffers, are helpful in mitigating overall systemic risk.