Stock Prices and CDS-spreads as Bank Default Indicators in the European Banking Sector

The importance of the health of the banking sector cannot be underestimated, especially not after the recent financial crisis. Credit rating agencies base their ratings on backward-looking accounting information which cannot be used to predict a bank default. Therefore, it is of high relevance to develop market-based measures of default to give a point-in-time indication of the health of the banking sector. In this study, two measures of default will be compared; one developed by Hall and Miles (1990) which is based on stock prices and second one using a CDS spread. The study will be applied on the European banking sector where the 25 banks included in the study have been selected from the European Banking Authority’s stress test. By using a GARCH (1, 1) model applied on daily stock returns significant results indicate that conditional variances add information in predicting returns. The relationship between the measures based on stocks and the CDS spreads are strongly negative for most of the banks which proves the underlying theory behind these measures