Welcome Credit Derivatives in Banking : Useful Tools for Loan Risk Management ?

Previously circulated under the title \Banks and credit derivatives: Is it always good to have more risk management tools?" Abstract We model the eeects 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 trigger the bank's nancial distress. Because credit derivatives are more exible 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 nd 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. If so, the existence of a credit derivatives market will lead to a greater risk of bank insolvency. We thank George Fenn, Jeremy Stein, staa at J. P. Morgan, and participants at Wharton's Conference on Risk Management in Banking for helpful discussions and comments. All errors are our own. The analysis and conclusions of this paper are those of the authors and do not indicate concurrence by the Board of Governors or the Federal Reserve Banks. The authors can be reached at 202-452-3055, [email protected] (Duuee) and 202-452-3328, [email protected] (Zhou).