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Credit Derivatives in Banking: Useful Tools for Managing Risk?

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  • Gregory R. Duffee and Chunsheng Zhou.

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 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.

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Bibliographic Info

Paper provided by University of California at Berkeley in its series Research Program in Finance Working Papers with number RPF-289.

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Date of creation: 01 Nov 1999
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Handle: RePEc:ucb:calbrf:rpf-289

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  1. Carlstrom, Charles T. & Samolyk, Katherine A., 1995. "Loan sales as a response to market-based capital constraints," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 627-646, June.
  2. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  3. Berger, Allen N & Udell, Gregory F, 1995. "Relationship Lending and Lines of Credit in Small Firm Finance," The Journal of Business, University of Chicago Press, vol. 68(3), pages 351-81, July.
  4. Gregory R. Duffee, 1996. "Rethinking risk management for banks: lessons from credit derivatives," Proceedings 514, Federal Reserve Bank of Chicago.
  5. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
  6. Mauer, David C & Lewellen, Wilbur G, 1987. " Debt Management under Corporate and Personal Taxation," Journal of Finance, American Finance Association, vol. 42(5), pages 1275-91, December.
  7. Allen N. Berger & Gregory F. Udell, 1991. "Securitization, risk, and the liquidity problem in banking," Finance and Economics Discussion Series 181, Board of Governors of the Federal Reserve System (U.S.).
  8. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
  9. Mitchell A. Petersen & Raghuram G. Rajan, 1994. "The Effect of Credit Market Competition on Lending Relationships," NBER Working Papers 4921, National Bureau of Economic Research, Inc.
  10. Stein, Jeremy C., 1987. "Informational Externalities and Welfare-Reducing Speculation," Scholarly Articles 3660740, Harvard University Department of Economics.
  11. Charles T. Carlstrom & Katherine A. Samolyk, 1993. "Loan sales as a response to market-based capital constraints," Working Paper 9313, Federal Reserve Bank of Cleveland.
  12. Petersen, Mitchell A & Rajan, Raghuram G, 1994. " The Benefits of Lending Relationships: Evidence from Small Business Data," Journal of Finance, American Finance Association, vol. 49(1), pages 3-37, March.
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