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Credit Default Swaps and the Stability of the Banking Sector

35 Pages Posted: 1 Mar 2010  

Frank Heyde

Martin-Luther Universität Halle-Wittenberg

Ulrike Neyer

Heinrich-Heine-University Duesseldorf

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Abstract

This paper considers credit default swaps (CDSs) used for the transfer of credit risk within the banking sector. The banks' motive to conclude these CDS contracts is to improve the diversification of their credit risk. It is shown that these CDSs reduce the stability of the banking sector in a recession. However, during a boom or in periods of moderate economic up- or downturn, they may reduce this stability. The main reasons behind these negative impacts are firstly, that banks are induced to increase their investment in an illiquid, risky credit portfolio, and secondly, that these CDSs may create a possible channel of contagion.

Suggested Citation

Heyde, Frank and Neyer, Ulrike, Credit Default Swaps and the Stability of the Banking Sector. International Review of Finance, Vol. 10, Issue 1, pp. 27-61, March 2010. Available at SSRN: https://ssrn.com/abstract=1560184 or http://dx.doi.org/10.1111/j.1468-2443.2010.01104.x

Frank Heyde (Contact Author)

Martin-Luther Universität Halle-Wittenberg ( email )

Sachsen-Anhalt

Ulrike Neyer

Heinrich-Heine-University Duesseldorf ( email )

Department of Economics
Universitaetsstrasse 1
Duesseldorf, 40225
Germany

HOME PAGE: http://www.economics-neyer.uni-duesseldorf.de

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