Keywords: Credit default swaps, bank loans, loan sales, asymmetric information
Abstract: We model the effects on banks of the introduction of a market for
credit derivatives--in particular, credit default swaps. A bank can
use such swaps to temporarily transfer credit risks of their loans to
others, reducing the likelihood that defaulting loans would trigger
the bank's financial distress. Because credit derivatives are more
flexible at transferring risks than are other, more established tools,
such as loan sales without recourse, these instruments make it easier
for banks to circumvent the ``lemons'' problem caused by banks'
superior information about the credit quality of their loans.
However, we find that the introduction of a credit derivatives market
is not necessarily desirable because it can cause other markets for
loan risk-sharing to break down. In this case, the existence of a
credit derivatives market will lead to a greater risk of bank
Full paper (190 KB PDF)
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