# Presentation: 160431

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

- Bernadette Minton, René M. Stulz and Rohan Williamson

## Slide 2

## 	“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

- 	Allan Greenspan

## 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?

## 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

## 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

## 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

## 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

## CDS users: Percent of BHCs that use credit derivativesN/L All: Notional Credit Derivatives/Loans average across all BHCsNB/L Users: Notional Net Protection Bought/Loans average across all users

## 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

## Alternatives in 2003

- 23.19% of banks sell 1-4 family residential loans
- 3.19% sell C&I loans
- 12.75% securitize residential loans; 3.19% securitize C&I loans
- 56.23% use interest rate derivatives

## 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.

## 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

## Predictions

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

## 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

## 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

## 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

## 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?

## Banks with net protection buying

- Much larger
- More C&I 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

## 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

## 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 C&I loans are more likely to hedge

## Slide 22

## Slide 23

## Slide 24

## Case Analysis

- So few banks, we can look at each
- A number of banks with net buying don’t disclose having net buying to hedge
- So, we may overstate hedging

## 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

## 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