A Market‐Based Measure of Credit Portfolio 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 embedded 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). This indicator represents the perceived share of high‐risk exposures in a bank's portfolio and can be used as a risk weight for computing regulatory capital requirements. We estimate CRIs for the 150 largest U.S. bank holding companies. We find that their CRIs are able to forecast bank failures and share price performances during the crisis of 2007–2009, even after controlling for a variety of traditional asset quality and general risk proxies.This paper was accepted by Wei Xiong, finance.