Credit derivatives in banking: useful tools for managing risk?

Greg Duffee and Chunsheng Zhou

No 1997-13, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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 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.

Keywords: Derivative securities; Risk (search for similar items in EconPapers)
Date: 1997
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Citations: View citations in EconPapers (8)

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Related works:
Journal Article: Credit derivatives in banking: Useful tools for managing risk? (2001)
Working Paper: Credit Derivatives in Banking: Useful Tools for Managing Risk? (1999)
Working Paper: Credit Derivatives in Banking: Useful Tools for Managing Risk? (1999)
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