How Much Do Banks Use Credit Derivatives to Hedge Loans?

An interesting paper by Bernadette A. Minton & René Stulz & Rohan Williamson is How Much Do Banks Use Credit Derivatives to Hedge Loans?:

Before the credit crisis that started in mid-2007, it was generally believed by top regulators that credit derivatives make banks sounder. In this paper, we investigate the validity of this view. We examine the use of credit derivatives by US bank holding companies with assets in excess of one billion dollars from 1999 to 2005. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2005 the gross notional amount of credit derivatives held by banks exceeds the amount of loans on their books. Only 23 large banks out of 395 use credit derivatives and most of their derivatives positions are held for dealer activities rather than for hedging of loans. The net notional amount of credit derivatives used for hedging of loans in 2005 represents less than 2% of the total notional amount of credit derivatives held by banks and less than 2% of their loans. We conclude that the use of credit derivatives by banks to hedge loans is limited because of adverse selection and moral hazard problems and because of the inability of banks to use hedge accounting when hedging with credit derivatives. Our evidence raises important questions about the extent to which the use of credit derivatives makes banks sounder.

Our evidence helps understand why the use of credit derivatives for hedging is limited. First, the market for credit derivatives is the most liquid for investment grade corporations and for countries. As a result, use of credit derivatives is going to be more intense for firms that have exposures to such credits, which we find to be the case. Second, for non-investment grade corporates, the market for credit derivatives is less liquid. Further, private information is more important for banks for loans to such corporates. As a result, hedging will be more expensive and banks will hedge such loans less. Using disclosures of banks, we find that banks that report hedging across credit ratings hedge relatively more credits that are less risky, which is consistent with our prediction. Finally, hedge accounting cannot typically be used for credit derivatives.

For 2005, we show that the total credit protection bought and sold by banks is roughly $5.5 trillion. In comparison, the net protection bought, which is a measure of hedging of credit risks, is roughly $0.5 trillion, or less than 10% of the overall credit derivatives gross positions of banks. While, the net protection bought is small compared to the loans of the banks that have positions in credit derivatives, the gross position of these banks is large compared to the loans they write. Consequently, since credit derivatives are used only to a limited extent to hedge loans, they can only make banks and the financial system sounder if they create few risks for banks when the banks take positions in them for other reasons than to hedge loans. Contrary to the optimistic view of regulators before 2007, the subprime crisis has shown that the dealer positions of banks in credit derivatives have substantial risks.

I’m not sure if it makes much sense for banks to systematically hedge their loan exposures through CDS. It seems to me that the whole point of being a bank in the first place is to hedge your issuer-specific risk through diversification and excess margin.

This is interesting in light of the CIT affair. When CIT drew down its credit lines – as reported on PrefBlog on March 20, 2008, CDS spreads spiked up to 27% up front and 500bp p.a. instantly – I recall, but cannot substantiate the existence of, rumours to the effect that this was due to bank buying.

This would make more sense, since CIT was drawing on credit lines with a pre-arranged spread. The Boston Fed looked at this issue. It is also my understanding that a lot of new lines are being negotiated as a spread off of CDS levels, which strikes me as a much better use of CDS by banks.

I can only hope the authors will re-examine the issue as data from the Credit Crunch trickles in!

One Response to “How Much Do Banks Use Credit Derivatives to Hedge Loans?”

  1. prefhound says:

    I thought another bank use of CDS was to sell them to create artificial loans (expanding and/or diversifiying the loan portfolio). A bank with a concentrated loan to Firm A could buy CDS for some of the A loan and sell CDS for Firm B and end up “diversified”.

    I’m not sure if this behaviour would show up in the “net” positions of $0.5T cited in the article.

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