The relationship between the physical and pricing measure in credit markets

During the financial and sovereign crisis, governments protected the financial system from a collapse. The transfer of impaired assets to a bad bank, or a guarantee on these assets, is one of the state aid measures applied by governments to preserve financial stability. The transfer price or guaranteed value is crucial in the assessment of state aid. The real challenge is thus to determine the state-aid-compatible value of impaired assets, which is called the Real Economic Value (REV). The REV of a portfolio of impaired assets is based on a valuation methodology that was established by the European Commission. This methodology uses, inter alia, a suitable credit risk premia. It is therefore important to compare the risk premia actually applied in the REV method to the long-term average risk premia.

For that reason, we examine the relative credit risk premium, also called coverage ratio, which is the ratio between the actual and risk-neutral default probability. The latter is the default probability derived from market quotes. The coverage ratio captures the magnitude of distress and perceived risk in credit markets. We consider coverage ratios for different time periods and quantify its long-term average value. Special attention is given to the financial and sovereign crisis and their impact on credit risk premia. We compute the actual default probabilities from yearly transition matrices, while the risk-neutral default probabilities are estimated from credit default swaps. We find that the long-term coverage ratios increased by 30 to 80%. Our results show that coverage ratios have increased since 2008 and that its post-crisis levels (after 2012) are still higher compared to pre-crisis values. If one interprets this increase as a permanent shift in risk premia, it will impact corporates' funding costs.

To study the differences between industries in terms of credit risk premia, we change the estimates for the actual default probability and use Moody's Expected Default Frequencies (EDF). For the banking sector, we observe an underestimation of the credit risk before the financial crisis and even after the sovereign crisis this underestimation persists, although to a lesser extent. This observation raises doubts about the applied recovery rate assumption of 40% for senior debt. We examine therefore if the risk-neutral recovery rates for the banking sector are different from this standard value. To this end, we apply and extend the model of Schläfer and Uhrig-Homburg (2014). The model assumes absolute priority rule, which reinforces that senior creditors are paid back in full before the subordinated debt holders can recover their investment. Historical data shows that for the banking sector the absolute priority rule is not always respected and thus senior debt holders transfer a certain amount of the value, to which they are entitled, to the subordinated debt holders. We include absolute priority rule violation in the model and adjust it to the bank specific liability structure.

We find empirical evidence that credit markets assume absolute priority rule violation and that the standard assumption of a risk-neutral recovery rate of 40% is not valid for senior debt of European banks in the considered time period. Our estimates are higher than these standard assumptions. In the case of absolute priority rule violation, the average recovery rate implied by the market for senior and subordinated debt are respectively 82% and 73%. Comparing the average implied recovery rates with their historical counterparts indicates that the recovery risk premium is underestimated for senior debt and subordinated debt. The magnitude of the underestimation of the recovery risk premium on senior debt is smaller than the one on subordinated debt.

In the last part of this dissertation, we study banks' coverage ratios by incorporating implied recovery rates in the calculations of credit risk premia. Before the financial crisis (2006 and 2007), we still observe that the credit risk of European banks was underestimated. The credit risk premia increased during the financial and sovereign crisis and reduced again in the last years of our observation period (2006-2014). From the start of the financial crisis, we do not find evidence for the underestimation of banks' credit risk premia, which indicates a permanent shift in banks' coverage ratios. This observation points to higher financing costs on banks' debt compared to pre-crisis levels.

Our results imply that corporates will face, ceteris paribus, higher credit risk premia and thus higher financing costs on their debt. For banks, this finding is even more pronounced. With the new resolution regulation for banks, due to the enforcement of the strict application of the absolute priority rule, the implied recovery rates of subordinated debt will decrease. Given that the default probability stays the same, banks' subordinated debt will become more expensive. Our insights are valuable for state aid assessments, for pricing default-prone financial instruments and for risk management practices that estimate risk-neutral default and recovery rates.