Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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2017
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Sun, 31 Dec 2017

Why do banks use Credit Default Swaps (CDS)?

Inaki Aldasoro and Andreas Barth have a paper “Syndicated loans and CDS positioning” (BIS Working Papers No 679) that tries to answer this question in the context of syndicated loans. Unfortunately, they frame the problem in terms of hedging and risk reduction; I think this is not a useful way of looking at the usage of CDS by banks, though it makes perfect sense in other contexts. For example, if business is worried about the creditworthiness of a large customer, it might want to buy CDS protection. It is effectively paying an insurance premium to eliminate the credit risk, while earning the profits from selling to this customer. This works because credit risk is incidental to the business transaction.

For the bank, however, credit risk is the core of the business relationship. The natural response to concerns about the creditworthiness of a (potential) customer is to limit the lending to this customer. Granting a loan and then buying CDS protection is just a roundabout way of buying a risk free bond (or perhaps a very low risk bond). It is much simpler to just buy a government bond or something similar.

When we see a bank grant a loan and simultaneously buy CDS on the loan, we are not seeing a risk reduction strategy. Rather the bank has determined that this roundabout strategy is somehow superior to simply buying a government bond. We should be evaluating different scenarios that could cause this to happen:

  1. As in the earlier example of a non financial business, the bank is looking at the profits from the totality of the customer relationship that could be at risk if it did not grant the loan.

  2. The CDS is mispriced, and the bank is able to earn a higher yield than a government bond for the same level of risk. Effectively, the bank is arbitraging the bond-CDS basis. A hedge fund that is expecting an improvement in the credit profile of a company could either go long the bond or sell CDS protection on the bond. The former would require financing the investment at the relatively high funding cost of the hedge fund. In imperfect markets, it can be better for a well capitalized bank to buy the bond (financing the purchase at its low funding cost) and buy CDS protection from the hedge fund. Particularly, after the global financial crisis, this scenario has been quite common.

Aldasoro and Barth find that weaker banks are less likely than strong banks to buy CDS protection on their loans. They argue that weak banks have lower franchise value and have less incentive to hedge their risks. Bond-CDS arbitrage provides a simpler explanation; stronger banks have a competitive advantage in executing this arbitrage, and are likely to do it more than weaker banks.

Similarly Aldasoro and Barth find that lead arrangers are more likely to hedge their credit risk exposures than other syndicate members. This fits nicely with the total customer profitability explanation: the hedged loan may be similar to a government bond, but the syndication fees may make this a worthwhile strategy.

Posted at 17:25 on Sun, 31 Dec 2017     View/Post Comments (0)     permanent link