Credit Default Swaps as Indicators of Bank Financial Distress

We examine the ability of CDS contracts written on individual banks to provide market discipline. Changes in CDS spreads are found to represent a robust signal of bank failure, thus providing indirect market discipline. Furthermore, changes in CDS spreads provide information about the condition of banks which supplements that available from equity markets and contained in accounting metrics. Consistent results are detailed for both senior and subordinated CDS spreads. Our results hold for various cohorts, for excess and idiosyncratic changes in CDS and are robust to the use of alternative measures of bank distress, including rating downgrades and accounting risk.