How much do banks use credit derivatives to reduce risk? ..

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How much do banks use credit derivatives to
reduce risk?

• Bernadette Minton, René M. Stulz and Rohan
  Williamson

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• The new instruments of risk dispersion have
  enabled the largest and most sophisticated banks
  in their credit-granting role to divest
  themselves of much credit risk by passing it to
  institutions with far less leverage.
• Allan Greenspan

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The issue

• Tremendous growth in credit derivatives
• Credit derivatives are understood to be mostly
  credit default swaps (CDS)
• How much are they used to manage the risk of
  banking books?

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The approach

• Investigate use of credit derivatives by large
  U.S. bank holding companies
• Measure extent of use
• Investigate determinants of use
• Compare use of credit derivatives to other credit
  risk mitigation devices

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The main result

• Very few bank holding companies have CDS
  positions
• Those that have CDS positions have them mainly
  for trading
• Net buying for hedging is economically very small
• Why? Market is not and can not be liquid in the
  names that banks want to hedge

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The sample

• Federal Reserve Bank of Chicago Bank Holding
  Database
• All commercial bank holding companies with assets
  greater than 1 billion and non-missing data on
  credit derivatives
• 1999-2003
• Exclude banks which are major subsidiaries of
  foreign companies

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Characteristics

• 260 banks in 1999
• 345 banks in 2003
• Very skewed distribution Average 21 billion of
  assets in 2003, median 2 billion.
• Only 19 banks use credit derivatives in 2003

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CDS users Percent of BHCs that use credit
derivativesN/L All Notional Credit
Derivatives/Loans average across all BHCsNB/L
Users Notional Net Protection Bought/Loans
average across all users
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The story in 2003

• Gross Notional for all banks 1 trillion
• 26.75 of total loans
• 17 banks are net buyers
• Total net notional amount of protection bought is
  67 billion
• Average across net buyers is 2.84 of total loans

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Alternatives in 2003

• 23.19 of banks sell 1-4 family residential loans
• 3.19 sell CI loans
• 12.75 securitize residential loans 3.19
  securitize CI loans
• 56.23 use interest rate derivatives

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Skewed use

• JP Morgan has gross notional greater than loans
  577 billion versus 219 billion
• Out of 17 net buyers, 9 have gross protection
  bought less than 1 of loans
• Highest net protection bought as of loans is JP
  Morgan at 11.74
• Next, B of A, but Citi is net seller.

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Why banks hedge

• Diamond Banks should hedge all risks in which
  they do not have a comparative advantage
• Diamond/Rajan Banks benefit from leverage.
  Higher leverage is possible through hedging
• Schrand/Unal Hedging increases ability of banks
  to take risks in which they have a comparative
  advantage
• Smith/Stulz Hedging to decrease PV of distress
  costs

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Predictions

• Banks that hedge should
• Have less capital
• More non-performing loans
• Weaker liquidity
• Smaller margins
• Be larger

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Demand for CDS

• Choice Keep loan and hedge sell loan directly
  or through securitization
• Relationship concerns
• Adverse selection issues
• Incentives to monitor
• Economies of scale in derivatives use

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Supply of CDS

• Adverse selection concerns when bank is better
  informed
• Liquidity related to size
• Advantage of publicly traded debt and equity for
  price discovery

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Predictions

• Banks hedge with CDS when they make large loans
  to public companies or foreign countries
• So, banks with more residential loans,
  agricultural loans, car loans are less likely to
  use CDS
• Banks with trading activities would be more
  likely to use CDS to hedge counterparty risk

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Is net buying hedging?

• Maintained hypothesis
• What about the portfolio diversification
  argument?
• It requires banks to take credit exposures using
  CDS. What would be the point?

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Banks with net protection buying

• Much larger
• More CI loans
• Fewer loans secured by real estate
• Fewer agricultural loans
• More foreign loans
• Lower net margin
• Same return on assets but higher return on equity
• Less equity capital
• Much lower Tier 1 risk-adjusted capital ratio
• No difference in NPL
• Have dramatically more trading revenue to assets

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Substitutes or complements?

• Banks that use CDS are
• More likely to use securitization
• More likely to sell loans
• All use interest-rate derivatives
• More likely to use equity and commodity
  derivatives

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Regression analysis

• We find that banks with less capital are more
  likely to hedge with CDS
• More profitable banks are less likely to hedge
• Banks with more foreign and CI loans are more
  likely to hedge

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Case Analysis

• So few banks, we can look at each
• A number of banks with net buying dont disclose
  having net buying to hedge
• So, we may overstate hedging

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So, why is the use not greater?

• Market is illiquid for names that banks care
  about most
• Why? Banks have an advantage with names where
  they have more information, but this advantage
  makes the CDS market illiquid for those names

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Conclusion

• The economic importance of credit derivatives in
  hedging the banking book is very limited
• The economic reason is straightforward The
  market is not liquid for the names banks would
  want to hedge most because information
  asymmetries are too great for these names