European Banks' Implied Recovery Rates

We examine recovery rates of the European banking sector. To this end, we employ information embedded in credit default swaps (CDS) with different levels of seniority. To estimate implied recovery rates, we extend the model of Schlafer and Uhrig-Homburg (2014) and include absolute priority violation. We fit the extended model and find that the implied recovery rates are much higher than the ones usually applied in pricing formulas. Since the implied recovery rates are estimated from traded instruments, we obtain recovery rates under the so-called pricing measure Q. They incorporate potentially risk premia and differ from physical or historical rates. We also attempt to estimate the impact of the new resolution regulation in the EU on implied recovery rates. When we compare implied recovery rates with historical ones, we observe an underestimation of the recovery risk premium for senior debt and subordinated debt. However, the negative risk premium on subordinated debt has a larger magnitude. Our results are relevant for pricing models of default-prone instruments and risk management practices that require implied recovery and default rates.