A Market Based Measure of Credit Quality and Banks' Performance During the Subprime Crisis

We propose a new method for measuring the quality of banks credit portfolios. This method makes use of information impounded in bank share prices by exploiting differences in their sensitivity to credit default swap spreads of borrowers of varying quality. The method allows us to derive a credit risk indicator (CRI), which is the perceived share of high risk exposures in a bank's portfolio. We estimate CRIs for the 150 largest U.S. bank holding companies and find that they have strong predictive power for the BHCs' performance during the subprime crisis, even after controlling for a variety of traditional asset quality proxies. Interestingly, we also find that the BHCs' aggregate CRI did not deteriorate since the beginning of the subprime crisis. This suggests that the market was aware of their (average) exposure to high risk credit.