Banks and Credit Derivatives

Minton, Stulz, and Williamson have an important look at banks' usage of credit derivatives. The short version? Very few banks are using them! In 2003, only about 6% of banks with over $1B in assets report using this form of derivatives. Consistent with what we have seen on other derviatve usage, these banks tend to be much larger than average. Best guess as for the low usage? Transaction costs driven by moral hazard and adverse selection costs.

Slightly longer version of the paper

Minton, Stulz, and Williamson begin by documenting that the credit derivative market (measured by notional principle) has grown in recent years. Regulators (and even Alan Greenspan himself) have claimed that this reduces the risks that banks face. The paper investigates banks' use of credit derivatives and find that as of 2003, few banks were using credit derivatives. Those banks that were using the derivatives tended to be larger and have a greater need for the risk reduction.

In the words of the paper's authors:

"...net buyers of protection have higher levels of risk than other banks: they have lower capital ratios, lower balances of liquid assets, a higher ratio of risk-based assets to total assets, and a higherfraction of non-performing assets than the non-users of credit derivatives."

Why the limited use? Transaction costs undoubtedly play a role. Like in other derivatives "know-how" can be expensive to obtain and this largely fixed cost may explain a portion of the limited use. However, the very nature of credit derivatives also makes them prone to moral hazard and adverse selection costs. (Tried another way, banks typcially know more about the borrowers (and are often in a better position to monitor), than do derivative market participants. This results in less liquidity (higher transaction costs) for the very loans that would make the most sense to hedge.)

Again in the authors' words:

"These adverse selection and moral hazard problems make the market for credit derivatives illiquid for singlename protection precisely for the credit risks that banks would often want to hedge with such protection. The positive coefficient estimates on C&I loan and foreign loan shares in a bank’s loan portfolio are consistent with the hypothesis that banks are more likely to hedge with credit derivatives if they havemore loans to credits for which the credit derivatives market is more liquid."

So what does this all mean? The conclusion hints that the benefits of credit derivatives may be overstated but apparently teh cost of hedging in papers is lower than in the credit derivative market as the paper ends covering both sides of the debate:

"To the extent that credit derivatives make it easier for banks to maximize their value with less capital, they do not increase the soundness of banks as much as their purchases of credit derivatives would imply. However, if credit derivatives enable banks to save capital, they ultimately reduce the cost of loans for bank customers and make banks morecompetitive with the capital markets for the provision of loans."

Not only are few banks using the derivatives to hedge, the exact loans that the banks would want to hedge are the most expensive to do. This really should not be surprising. What is more surprising is that these costs are so high as to prevent the use of the derivatives. Going forward in time, it will be interesting to see if this remains the case or if as the market develops, new ways evolve to lower the costs which would allow more effective hedging with credit derivatives. Stay Tuned.

Cite:
Minton, Bernadette A, Rene Stulz, and Rohan Williamson. "How much do banks use credit derivatives to reduce risk?", Ohio State working paper, http://www.cob.ohio-state.edu/fin/dice/papers/2005/2005-17.pdf, accessed 8/17/05