Credit derivatives are bilateral financial contracts with payoffs linked to a credit related event such as a default, credit downgrade or bankruptcy. A bank can use a credit derivative to transfer some or all of the credit risk of a loan to another party or to take additional risks. In principle, credit derivatives are tools that enable banks to manage their portfolio of credit risks more efficiently. The promise of these instruments has not escaped regulators and policymakers.
In various speeches, Alan Greenspan concludes that credit derivatives and other complex financial instruments have contributed "to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago." (Greenspan , 2004 ). He further states in the same speech that "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."
Statistics from the Bank for International Settlements (BIS) show that the market for credit derivatives has grown dramatically in recent years. The notional amount of credit derivatives increased from $698 billion at the end of June 2001 to $4,664 billion by the end of June 2004, an annual growth rate of 88% (see BIS, 2004). The largest sector of the credit derivatives market is the credit default swap market where the most liquid names on which credit derivatives are written are large US investment grade firms, foreign banks, and large multinational firms (Fitch, 2004).
Despite the growth of the credit derivatives market, we know little about how banks use credit derivatives to change their credit exposures. In particular, we know of no published academic research which investigates whether banks systematically use credit derivatives to reduce their overall credit risk. In this paper, we examine the use of credit derivatives by U.S. bank holding companies with total assets greater than one billion dollars for the period from 1999 to 2003.
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How much do banks use credit derivatives to reduce risk?
