Half-full or Half-empty? Financial Institutions, CDS Use, and Corporate Credit Risk

Cecilia R. Caglio, Matthew Darst and Eric Parolin
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Cecilia R. Caglio: https://www.federalreserve.gov/econres/cecilia-r-caglio.htm

No 2018-047, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We construct a novel U.S. data set that matches bank holding company credit default swap (CDS) positions to detailed U.S. credit registry data containing both loan and corporate bond holdings to study the effects of banks' CDS use on corporate credit quality. Banks may use CDS to mitigate agency frictions and not renegotiate loans with solvent but illiquid borrowers resulting in poorer measures of credit risk. Alternatively, banks may lay off the credit risk of high quality borrowers through the CDS market to comply with risk-based capital requirements, which does not impact corporate credit risk. We find new evidence that corporate default probabilities and downgrade likelihoods, if anything, are slightly lower when banks purchase CDS against their borrowers. The results are consistent with banks using CDS to efficiently lay off credit risk rather than inefficiently liquidate firms.

Keywords: Bank lending; Credit default swaps; Risk management (search for similar items in EconPapers)
JEL-codes: G2 G21 G23 (search for similar items in EconPapers)
Pages: 61 pages
Date: 2018-07-19
New Economics Papers: this item is included in nep-ban and nep-rmg
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https://www.federalreserve.gov/econres/feds/files/2018047pap.pdf (application/pdf)

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Journal Article: Half-full or half-empty? Financial institutions, CDS use, and corporate credit risk (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2018-47

DOI: 10.17016/FEDS.2018.047

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