Does a Change in the TED Spread Impact Bank Stock Returns?

Abstract

During the economic crisis of 2008, the global economic system came under tremendous stress due to unusually high activity in the risk spread and volatility in the financial asset valuation. The spread between the US T-bill rate and the London interbank offer rate (LIBOR), a proxy for perceived counterparty credit risk called the “TED spread,” also increased during the crisis period and impacted other economic variables. This study examines the impact of credit risk, as represented by the TED spread, on the daily returns of the ABAQ index, which represents community banks, and the KBW index, which represents the money center and other major banks. The findings, based on daily data from 2010–2020, are as follows: An increase in credit risk led to a decrease in returns for both community banks and money center banks; however, the significance of credit risk and its impact on the stock returns of community banks and money center banks diminished when controlled for other stock market movements.

Key Findings

• ▪ The TED Spread is critical to investment valuation since it is an indicator of the price of money in the global banking system.

• ▪ As an indicator of the solvency of financial institutions, monetary liquidity, and perceived risk of the financial system, an increase in the TED spread impacts the daily returns of banks (community banks, money centers, and other major banks) negatively.

• ▪ An increase in the TED spread leads to the drying up of market liquidity that increases cost of funding and generates a negative reaction in the stock market. The study shows that stocks for both larger banks and community banks, while affected by the TED spread, are more impacted by general market movements.