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Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time

  • Nijskens, Rob
  • Wagner, Wolf

A main cause of the crisis of 2007-2009 is the various ways through which banks have transferred credit risk in the financial system. We study the systematic risk of banks before the crisis, using two samples of banks respectively trading Credit Default Swaps (CDS) and issuing Collateralized Loan Obligations (CLOs). After their first usage of either risk transfer method, the share price beta of these banks increases significantly. This suggests the market anticipated the risks arising from these methods, long before the crisis. We additionally separate this beta effect into a volatility and a market correlation component. Quite strikingly, this decomposition shows that the increase in the beta is solely due to an increase in banks' correlations. Thus, while banks may have shed their individual credit risk, they actually posed greater systemic risk. This creates a challenge for financial regulation, which has typically focused on individual institutions.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 35 (2011)
Issue (Month): 6 (June)
Pages: 1391-1398

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Handle: RePEc:eee:jbfina:v:35:y:2011:i:6:p:1391-1398
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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  1. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters, in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc.
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