1. How much do banks use credit derivatives to reduce risk? Bernadette Minton, René M. Stulz and Rohan Williamson

3. “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

4. 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?

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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.

13. 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

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

15. 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

16. 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

17. 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

18. 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?

19. 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

20. 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

21. 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

25. 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

26. 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

27. 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