Are banking systems increasingly fragile? Investigating financial institutions' CDS returns extreme co-movements

This paper investigates potential contagion among the major financial institutions in developed economies. Using Credit Default Swaps (CDS) premia as a measure of both credit and counterparty risks, our analysis focuses on the extreme co-movements of financial institutions' default swap contracts during the high level of stress undergone by the CDS markets in the aftermath of the 2007 sub-prime crisis. Our approach is twofold. First, under different tail dependence scenarios, we calibrate several multivariate linear models of constant correlation. Our Monte Carlo simulation study finds evidence of contagion for financial institutions, notably in the U.S., and captures a non-normal dependence structure in the tails for the traded contracts. Second, we estimate a multivariate Dynamic Conditional Correlation-GARCH (DCC-GARCH) model, and demonstrate significant ARCH and GARCH effects, as well as time-varying correlations in CDS spread variations. Our overall analysis rejects the assumption of constant correlation. More importantly, it advocates changing structures in the tail dependence for CDS returns series during times of financial turmoil as an important feature of banks' increased fragility.