Half-Full or Half-Empty? Financial Institutions, CDS Use, and Corporate Credit Risk

63 Pages Posted: 23 Jul 2018 Last revised: 18 Jun 2021

See all articles by Cecilia Caglio

Cecilia Caglio

Board of Governors of the Federal Reserve System

Matthew Darst

Board of Governors of the Federal Reserve System

Eric Parolin

Office of Financial Research

Date Written: July, 2018

Abstract

We construct a novel U.S. data set that matches bank holding company credit default swap (CDS) positions to detailed U.S. credit registry data containing both loan and corporate bond holdings to study the effects of banks' CDS use on corporate credit quality. Banks may use CDS to mitigate agency frictions and not renegotiate loans with solvent but illiquid borrowers resulting in poorer measures of credit risk. Alternatively, banks may lay off the credit risk of high quality borrowers through the CDS market to comply with risk-based capital requirements, which does not impact corporate credit risk. We find new evidence that corporate default probabilities and downgrade likelihoods, if anything, are slightly lower when banks purchase CDS against their borrowers. The results are consistent with banks using CDS to efficiently lay off credit risk rather than inefficiently liquidate firms.

JEL Classification: G2, G21, G23

Suggested Citation

Caglio, Cecilia and Darst, Matthew and Parolin, Eric, Half-Full or Half-Empty? Financial Institutions, CDS Use, and Corporate Credit Risk (July, 2018). FEDS Working Paper No. 2018-47, Available at SSRN: https://ssrn.com/abstract=3217783 or http://dx.doi.org/10.17016/FEDS.2018.047

Cecilia Caglio (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Matthew Darst

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Eric Parolin

Office of Financial Research ( email )

717 14th Street, NW
Washington, DC 20220
United States

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