How much do banks use credit derivatives to reduce risk?
-
Upload
shaine-hodges -
Category
Documents
-
view
25 -
download
0
description
Transcript of How much do banks use credit derivatives to reduce risk?
![Page 1: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/1.jpg)
How much do banks use credit derivatives to reduce risk?
Bernadette Minton, René M. Stulz and Rohan Williamson
![Page 2: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/2.jpg)
![Page 3: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/3.jpg)
“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
![Page 4: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/4.jpg)
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?
![Page 5: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/5.jpg)
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
![Page 6: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/6.jpg)
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
![Page 7: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/7.jpg)
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
![Page 8: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/8.jpg)
Characteristics
• 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
![Page 9: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/9.jpg)
CDS users: Percent of BHCs that use credit derivativesN/L All: Notional Credit Derivatives/Loans average across all BHCs
NB/L Users: Notional Net Protection Bought/Loans average across all users
CDSusers
N/L AllNB/L
Users
20012002
2003
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
![Page 10: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/10.jpg)
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
![Page 11: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/11.jpg)
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
![Page 12: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/12.jpg)
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.
![Page 13: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/13.jpg)
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
![Page 14: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/14.jpg)
Predictions
• Banks that hedge should:– Have less capital– More non-performing loans– Weaker liquidity– Smaller margins– Be larger
![Page 15: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/15.jpg)
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
![Page 16: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/16.jpg)
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
![Page 17: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/17.jpg)
Predictions
• 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
![Page 18: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/18.jpg)
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?
![Page 19: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/19.jpg)
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
![Page 20: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/20.jpg)
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
![Page 21: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/21.jpg)
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
![Page 22: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/22.jpg)
![Page 23: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/23.jpg)
![Page 24: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/24.jpg)
![Page 25: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/25.jpg)
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
![Page 26: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/26.jpg)
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
![Page 27: How much do banks use credit derivatives to reduce risk?](https://reader031.fdocuments.in/reader031/viewer/2022020716/56813472550346895d9b56e1/html5/thumbnails/27.jpg)
Conclusion
• 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