One of the main tools used by investors and policymakers to predict whether a company may default on its debt is riddled with problems, making it a potentially ineffective gauge for measuring the risks of large banks, according to International Monetary Fund economists.
Bank credit default swaps – which offer investors protection in the event of a default – were closely watched during the financial crisis with some critics arguing that they tipped some groups closer to collapse. But a recent working paper by Manmohan Singh and Karim Youssef, economists at the IMF, argue that they offer a flawed model for policymakers looking at potential losses and contagion among large banks in times of financial stress.
The problems centre around the big divergence in credit and equity markets during the crisis and the huge differences in how much can be recovered by investors once a bank defaults. “Not taking these elements into consideration may result in different, and perhaps misguided, results and policy recommendations,” wrote the economists. They argue that because banks were viewed as too big to fail, many of their CDS spreads failed to rise sharply in the crisis as bondholders did not expect to bear any losses.