European banks and Fed liquidity facilities during the Global Financial Crisis: Good news for the bad and bad news for the good

Abstract

During the 2007–2010 period the Fed operated various liquidity facilities that were intended to alleviate financial system stress but which could have been interpreted as an adverse signal on banking risk. To disentangle these two effects, we analyze the response of the credit default swap (CDS) market to the announcement and usage of these facilities by European banks, since the CDS spread can be considered as a proxy for market perceptions of bank risk. We find that Fed financial assistance tended to reduce market concern about bank risk at the beginning of the crisis and after the collapse of Lehman Brothers, showing its willingness to support the banks. However, between March and September 2008, while there was still some uncertainty about the severity of the crisis, the Fed’s programs seem to have worried market participants about banking risk. We also find that the announcement of the Fed’s programs was better received on the CDS market for banks that benefited from public assistance (as a bail-out) than for the other banks, thus seeming to effect a greater reduction of perceived risk for publicly assisted banks.