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Credit derivatives in banking: useful tools for managing risk?

  • Gregory R. Duffee
  • Chunsheng Zhou

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 would 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. In this case, the existence of a credit derivatives market will lead to a greater risk of bank insolvency.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1997-13.

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Date of creation: 1997
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Handle: RePEc:fip:fedgfe:1997-13
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  1. 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.
  2. Stein, Jeremy C., 1987. "Informational Externalities and Welfare-Reducing Speculation," Scholarly Articles 3660740, Harvard University Department of Economics.
  3. Petersen, Mitchell A & Rajan, Raghuram G, 1995. "The Effect of Credit Market Competition on Lending Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 407-43, May.
  4. 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.
  5. Gregory R. Duffee, 1996. "Rethinking risk management for banks: lessons from credit derivatives," Proceedings 514, Federal Reserve Bank of Chicago.
  6. 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.).
  7. 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.
  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. 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.
  10. 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.
  11. 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.
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