Credit Default Swaps and Bank Regulatory Capital
Review of Finance, forthcoming
50 Pages Posted: 20 Sep 2017 Last revised: 14 Jul 2020
Date Written: June 8, 2020
While credit default swaps (CDS) can be used to hedge credit risk exposures or to speculate, we examine another use of them: banks buy CDS referencing their borrowers to obtain regulatory capital relief. Such capital relief activities have unintended consequences, as banks extend riskier loans when they buy CDS to boost capital ratios. While capital-induced CDS-user banks achieve higher profitability during normal times, they perform worse and request more government support in crisis periods than other banks that use CDS for trading or speculation. Our findings suggest that banks’ CDS trading for capital relief purposes may make these banks riskier.
Keywords: Credit default swaps, CDS, Capital relief, RWA ratio, Bank risk-taking
JEL Classification: G21
Suggested Citation: Suggested Citation