Credit Derivatives in Banking: Useful Tools for Managing Risk?

TLDR

Credit default swaps allow banks to transfer loan credit risk, reducing distress and offering greater flexibility than traditional loan sales, thereby helping avoid the lemons problem. The study models the impact of introducing a credit derivatives market, specifically credit default swaps, on banks. The authors simulate the effects of a credit derivatives market on banks. They find that a credit derivatives market can undermine other loan risk‑sharing markets and increase banks’ insolvency risk.

Abstract

We model the effects on banks of the introduction of a market for credit derivatives--in particular, credit default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans would trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the "lemons" problem caused by banks' superior information about the credit quality of their loans. However, we find that the introduction of a credit derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down. In this case, the existence of a credit derivatives market will lead to a greater risk of bank insolvency.