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How much do banks use credit derivatives to reduce risk?. Bernadette Minton, Ren é M. Stulz and Rohan Williamson.

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how much do banks use credit derivatives to reduce risk

How much do banks use credit derivatives to reduce risk?

Bernadette Minton, René M. Stulz and Rohan Williamson

“The new instruments of risk dispersion have enabled the largest and most sophisticated banks in their credit-granting role to divest themselves of much credit risk by passing it to institutions with far less leverage.”

Allan Greenspan

the issue
The issue
  • Tremendous growth in credit derivatives
  • Credit derivatives are understood to be mostly credit default swaps (CDS)
  • How much are they used to manage the risk of banking books?
the approach
The approach
  • Investigate use of credit derivatives by large U.S. bank holding companies
  • Measure extent of use
  • Investigate determinants of use
  • Compare use of credit derivatives to other credit risk mitigation devices
the main result
The main result
  • Very few bank holding companies have CDS positions
  • Those that have CDS positions have them mainly for trading
  • Net buying for hedging is economically very small
  • Why? Market is not and can not be liquid in the names that banks want to hedge
the sample
The sample
  • Federal Reserve Bank of Chicago Bank Holding Database
  • All commercial bank holding companies with assets greater than $1 billion and non-missing data on credit derivatives
  • 1999-2003
  • Exclude banks which are major subsidiaries of foreign companies
260 banks in 1999

345 banks in 2003

Very skewed distribution: Average $21 billion of assets in 2003, median $2 billion.

Only 19 banks use credit derivatives in 2003


CDS users: Percent of BHCs that use credit derivativesN/L All: Notional Credit Derivatives/Loans average across all BHCsNB/L Users: Notional Net Protection Bought/Loans average across all users

the story in 2003
The story in 2003
  • Gross Notional for all banks: ~$1 trillion
  • 26.75% of total loans
  • 17 banks are net buyers
  • Total net notional amount of protection bought is $67 billion
  • Average across net buyers is 2.84% of total loans
alternatives in 2003
Alternatives in 2003
  • 23.19% of banks sell 1-4 family residential loans
  • 3.19% sell C&I loans
  • 12.75% securitize residential loans; 3.19% securitize C&I loans
  • 56.23% use interest rate derivatives
skewed use
Skewed use
  • JP Morgan has gross notional greater than loans: $577 billion versus $219 billion
  • Out of 17 net buyers, 9 have gross protection bought less than 1% of loans
  • Highest net protection bought as % of loans is JP Morgan at 11.74%
  • Next, B of A, but Citi is net seller.
why banks hedge
Why banks hedge
  • Diamond: Banks should hedge all risks in which they do not have a comparative advantage
  • Diamond/Rajan: Banks benefit from leverage. Higher leverage is possible through hedging
  • Schrand/Unal: Hedging increases ability of banks to take risks in which they have a comparative advantage
  • Smith/Stulz: Hedging to decrease PV of distress costs
  • Banks that hedge should:
    • Have less capital
    • More non-performing loans
    • Weaker liquidity
    • Smaller margins
    • Be larger
demand for cds
Demand for CDS
  • Choice: Keep loan and hedge; sell loan directly or through securitization
  • Relationship concerns
  • Adverse selection issues
  • Incentives to monitor
  • Economies of scale in derivatives use
supply of cds
Supply of CDS
  • Adverse selection concerns when bank is better informed
  • Liquidity related to size
  • Advantage of publicly traded debt and equity for price discovery
  • Banks hedge with CDS when they make large loans to public companies or foreign countries
  • So, banks with more residential loans, agricultural loans, car loans are less likely to use CDS
  • Banks with trading activities would be more likely to use CDS to hedge counterparty risk
is net buying hedging
Is net buying hedging?
  • Maintained hypothesis
  • What about the portfolio diversification argument?
  • It requires banks to take credit exposures using CDS. What would be the point?
banks with net protection buying
Banks with net protection buying
  • Much larger
  • More C&I loans
  • Fewer loans secured by real estate
  • Fewer agricultural loans
  • More foreign loans
  • Lower net margin
  • Same return on assets but higher return on equity
  • Less equity capital
  • Much lower Tier 1 risk-adjusted capital ratio
  • No difference in NPL
  • Have dramatically more trading revenue to assets
substitutes or complements
Substitutes or complements?
  • Banks that use CDS are:
    • More likely to use securitization
    • More likely to sell loans
    • All use interest-rate derivatives
    • More likely to use equity and commodity derivatives
regression analysis
Regression analysis
  • We find that banks with less capital are more likely to hedge with CDS
  • More profitable banks are less likely to hedge
  • Banks with more foreign and C&I loans are more likely to hedge
case analysis
Case Analysis
  • So few banks, we can look at each
  • A number of banks with net buying don’t disclose having net buying to hedge
  • So, we may overstate hedging
so why is the use not greater
So, why is the use not greater?
  • Market is illiquid for names that banks care about most
  • Why? Banks have an advantage with names where they have more information, but this advantage makes the CDS market illiquid for those names
  • The economic importance of credit derivatives in hedging the banking book is very limited
  • The economic reason is straightforward: The market is not liquid for the names banks would want to hedge most because information asymmetries are too great for these names