How much should creditors worry about operational risk? The credit default swap spread reaction to operational risk events

ABSTRACT This paper examines the credit default swap (CDS) market's reaction to operational risk events in the banking industry, and thus addresses the question of the extent to which operational risk affects the default risk of the banks. The analysis is based on a sample of ninety-nine operational losses occurring at large European financial institutions between January 2004 and September 2010. Previous literature studying the market reaction to operational risk events has so far only focused on the stock and bond markets. This paper complements and extends existing literature by being the first to provide empirical evidence on the topic from the CDS market. The results shed light on the impact of operational losses on the default risk of banks, which is important not only for creditors but also from a regulatory point of view. On average, there is a statistically significant increase in CDS spreads around the settlement date of losses in the range of five basis points, or roughly 5% in relative terms. Multivariate regressions show that the CDS market's reaction to operational risk events is influenced by the (relative) size of losses. Moreover, the increase in CDS spreads is more pronounced for banks with a good credit rating, while internal fraud events do not seem to be particularly harmful.