An Analysis of Financial Stability Indicators in European Banking: The Role of Common Factors

Tjalling C. Koopmans Research Institute

Tjalling C. Koopmans Research Institute
Utrecht School of Economics
Utrecht University

Janskerkhof 12
3512 BL Utrecht
The Netherlands
telephone +31 30 253 9800
website www.koopmansinstitute.uu.nl

The Tjalling C. Koopmans Institute is the research institute
and research school of Utrecht School of Economics.
It was founded in 2003, and named after Professor Tjalling C.
Koopmans, Dutch-born Nobel Prize laureate in economics of
1975.

In the discussion papers series the Koopmans Institute
publishes results of ongoing research for early dissemination
of research results, and to enhance discussion with colleagues.

Please send any comments and suggestions on the Koopmans
institute, or this series to M.deSwart-Gijsbers@econ.uu.nl

ontwerp voorblad: WRIK Utrecht



How to reach the authors

Please direct all correspondence to the first author.

Clemens Kool
Utrecht University
Utrecht School of Economics
Janskerkhof 12
3512 BL Utrecht
The Netherlands.
E-mail: c.kool@econ.uu.nl



This paper can be downloaded at: http://www.koopmansinstitute.uu.nl

Utrecht School of Economics
Tjalling C. Koopmans Research Institute
Discussion Paper Series 06-12




AN ANALYSIS OF FINANCIAL STABILITY
INDICATORS IN EUROPEAN BANKING:
THE ROLE OF COMMON FACTORS


Clemens Koola


aUtrecht School of Economics
Utrecht University

December 2006


Abstract
In this paper, we investigate the information content of three market indicators of
financial instability using daily data on subordinated debt spreads (SND), credit
default swap spreads (CDS) and implied option volatility (IV) over the period
January 2001 – January 2004 for a sample of twenty major European banks. Using
common factor analysis, we find for each indicator a significant common factor
across banks, which we label the “market” factor. This market factor explains
between 61 and 92 percent of total variation. Cointegration analysis shows that the
market factor in each case is significantly related to macro financial variables such
as the short term nominal interest rate, the yield spread and a European Price
earning stock ratio. Hence, market risk is primarily affected by aggregate economic
and financial developments which are widely seen to impact financial markets. The
driving variables of market risk are different for the bond and equity markets with
short-term interest rates and yield curve dominating the bond market (SND) and
P/E ratio and short-term interest rate significantly influencing the equity market
(IV). The CDS market seems to lie somewhat in between these two classical
markets, with closer links, however, to the traditional bond market. Little evidence is
found that idiosyncratic bank-specific risks are a major component of SND, CDS and
IV developments.

Keywords: Credit Default Swap Spreads, Risk Premium, Financial Integration

JEL classification: G12, G15, G21, C30

1

1. Introduction

The social benefits of an effective financial system are commonly acknowledged. It is
widely accepted that finance contributes to an efficient allocation of real economic
resources across time and space, an efficient management of wealth and capital
accumulation, both main drivers for development and growth.1 Modern finance also
enables the management of economic and financial risk in a globally integrated economic
system by pricing, repackaging and transferring risks. The important role of banks –
besides financial markets - as intermediary agent or institution in the process of asset
allocation is also widely accepted. Following this line of reasoning, there is also a clear
social benefit in maintaining this system and its institutions, which hence should be a
policy objective.2 In this respect, “there is clear empirical and theoretical evidence that, at
times, public intervention may be required to ensure financial stability. (…)Banking is
indeed a business plagued by an inherent instability, which cannot be removed if its
economic benefits are to be realised”3. At the centre of these problems is the maturity-
mismatch between loans and deposits, intrinsic to the banks’ business. However, it has to
be underlined that “the evil to be avoided is not the failure of just a single bank”4. Market
entry and exit is a normal process in the banking sector as in any other industry.
Nonetheless, the risk of contagion, “recognised as key component in the development of
many financial crises”5, makes supervision necessary, also on a micro level. Yet,
supervision on a micro-level is only a means to the end of insuring systemic, macro-
stability. The question of how different sources of information interact is precisely what
is at the core of the present study.

A practical problem is the fact that situations of distress in the European financial system
leading to ultimate bank failures, such as in the case of Bankhaus Herstatt in 1974 or
Barings in 1995, lay relatively far behind in history and are rare. Nonetheless, the recent
past has shown a number of situations when financial markets seem to have been

1 The three roles of modern finance mentioned are presented in “Towards an Understanding of the Meaning
of Financial Stability” by Garry Schinasi (2003). The author points out that the capital accumulation might
even extend to the accumulation of human capital in modem and highly developed economies.
2 Whereas the latter view is shared by most academics, the precise definition of “financial stability” and its
policy-implications are controversial. In fact, numerous definitions coexist while some central banks, which
regularly publish so-called financial stability reports, tend even to avoid the task of defining financial
stability or acknowledge the elusiveness of a consistent definition. Tommaso Padoa-Schioppa (2003)
presents the following definition: “in general, the core economic functions of the financial system consist in
channelling savings into investments and providing for an efficient and safe payment mechanism. Along
these lines, I would suggest defining financial stability as a condition where the financial system is able to
withstand shocks without giving way to cumulative processes which impairs the allocation of savings to
investment opportunities and the processing of payment in the economy.”
3 Padoa-Schioppa, T. (2003)
4 see above
5 see above

2
considerably preoccupied by the financial soundness of several European banks.6
Situations of substantial financial distress remain a concrete threat.

Generally, financial stability analysis is based on indicators which provide a measure of
the stability of individual financial institutions as well as of the entire financial system.
Traditionally, this has been accomplished by carrying out on-site inspections of banks in
regular intervals and by analysing financial accounting ratios. In recent years, integrating
market data into this framework has been an important tendency, supported by the low–
cost and high-frequency availability of market data. Commonly used market indicators
today are for example subordinated debt spreads, equity prices and equity returns. The
current study is an extension of the important research which has been undertaken in this
area. It focuses on credit default swaps (CDS) spreads7, and aims at integrating CDS in
the framework of market indicators of financial stability.

CDS are one of the novel credit risk transfer instruments whose use has strongly
increased during the recent past. CDS offer protection on default of a credit, comparable
to credit insurance, by requiring a regular fee to be paid, the premium or CDS spread, in
exchange for protection, a compensation in case of default. The focus in this paper,
however, is not on the asset as such but rather on the “price” of it, the CDS spread. The
reason is that CDS spreads exhibit two important properties which suggest that,
theoretically at least, they are good candidates for financial stability indicators. As will be
shown, CDS spreads adequately reflect bank risk and moreover exhibit a high pricing
efficiency. In spite of this, CDS have hardly received any attention in the context of
financial stability analysis so far.

In order to test how CDS spreads act as stability indicator in practise, their properties will
be examined in comparison to two other indicators, subordinated debt spreads and
implied volatility8. This implies analysing a number of aspects in detail: 1) how do the
indicators capture bank-specific and common risk effects? 2) What are the underlying
(risk-)dimensions of the indicators? 3) Can a market risk dimension be identified? 4) If
so, what are its properties and is market risk related to a number of overall financial
indicators?

The paper is set up as follows. In section 2, we will give a brief literature review, while
we define the three indicators of financial stability used in this paper in section 3. In
section 4 we present data and methodology. Section 5 contains the empirical results and
discussion, while we conclude in section 6.


2. Literature review


6 See for example Financial Times, 14 October 2002, “Bad debts, falling capital, dismal profits”
7 For more information on CDS and the CDS market, see Annex I.
8 For an example of the practical use of the mentioned indicators, see for example the most recent “EU
banking sector stability” report by the ECB, November 2003, available at www.ecb.int