Credit Risk Transfer Activities and Systemic Risk: How Banks Became Less Risky Individually But Posed Greater Risks to the Financial System at the Same Time

16 Pages Posted: 24 Dec 2008 Last revised: 9 Jan 2012

See all articles by Rob Nijskens

Rob Nijskens

De Nederlandsche Bank

Wolf Wagner

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM); Centre for Economic Policy Research (CEPR)

Date Written: December 23, 2008

Abstract

A main cause of the ongoing financial crisis is the various ways through which banks have transferred credit risk in the financial system. In this paper we study the riskiness of banks that have used these methods, as perceived by the market. For this we analyze a sample of banks that trade Credit Default Swaps (CDS) and a sample of banks that issued Collateralized Loan Obligations (CLOs) between 1997 and 2006. We find that after their first usage of either risk transfer method, these banks experience a large and significant permanent increase in their share price beta. This suggests that the market was aware of the risks arising from these methods, long before the actual onset of the crisis. We also address the question of the source of the beta effect by separating it into a volatility and a market correlation component. Quite strikingly we find that the increase in the beta is solely due to an increase in banks' correlations. The volatility of these banks' returns actually declines. This suggests that banks undertaking credit risk transfer activities may appear individually less risky, while actually posing a greater risk for the financial system. We argue that this posits a challenge for financial regulation, which has typically focused on the level of the individual institution.

Keywords: securitization, credit derivatives, systemic risk, subprime crisis

JEL Classification: G21, G28

Suggested Citation

Nijskens, Rob and Wagner, Wolf, Credit Risk Transfer Activities and Systemic Risk: How Banks Became Less Risky Individually But Posed Greater Risks to the Financial System at the Same Time (December 23, 2008). Available at SSRN: https://ssrn.com/abstract=1319689 or http://dx.doi.org/10.2139/ssrn.1319689

Rob Nijskens

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands
+31 20 524 3234 (Phone)

Wolf Wagner (Contact Author)

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM) ( email )

P.O. Box 1738
Room T08-21
3000 DR Rotterdam, 3000 DR
Netherlands

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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