Credit Default Swaps and the Global Financial Crisis: Reframing Credit Default Swaps as Quasi-Insurance

Abstract

Credit Default Swaps coupled with asset-backed financial products were heavily traded in the years preceding the Global Financial Crisis. Intended for sophisticated investors, Credit Default Swaps prima facie are in the nature of insurance contracts, although they operate outside the scope of the regulation governing insurance. This paper adopts a lexonomic approach to take an initiative to develop a regulatory framework for Credit Default Swaps in order to prevent a similar crisis. Inter alia, one solution is to regulate Credit Default Swaps together with insurable interest and an "excess" in order to minimize moral hazard. The objective behind the excess is to discourage negligent lending.

Political and Institutional Dynamics of the Global Financial Crisis

“…Humans never seems to learn from their mistakes as greed becomes the prominent decision making factor for the human-financial decision making. 4 The main factor that distinguish GFC from the rest of the crises is the fact that DFC 2007 is based on a housing bubble. Yet, ironically all financial crises are based on some sort of an asset.…”

“…As had conventionally been the case, the purpose of much of this financial innovation was to minimise risk and enhance expected returns by 6 For example, credit default swaps were outside the ambit of the Commodity reducing bank funding costs, differentiating fundamentally similar products, 7 and for balance sheet management purposes. In addition however, much of this innovation-in particular, securitization contacts themselves and credit default swaps, which were designed to compensate investors when security issuers defaulted-was designed to transfer credit risk and liquidity risk [4,5]. Almost by definition, financial innovation implies risk and uncertainty.…”

“…State of New York amended the insurance law to exclude CDOs from coverage. The justification is that CDS are dealing with institutional investors but not consumers [4,25]. 29 1.…”

“…Internationally, central banks in consultation with their governments intervened in their respective economies by markedly reducing official or cash rates; injecting liquidity into the system by effectively lending to primary dealers (e.g. by allowing them to swap less liquid asset-backed securities for Treasury securities, often at a substantial discount); and so-called government 'bailouts' of securitizing institutions perceived to be economically significant or 'too big to fail' (such as Northern Rock in Britain; and Bear Stearns, Fannie Mae and Freddie Mac in the U.S.) [4,5]. 2 In subsequent months, real economies in the United States, Britain and elsewhere in Europe have exhibited historically poor performance, with relatively high unemployment and low economic growth, despite relatively low interest rates and inflation.…”

An Interest Rate Commission Agent Banking System

“…In the credit risk transfer market, banks used a credit default swap for more than a decade, but the irresponsible use of credit default swaps and other derivatives became a major cause of financial institutions' problems during the recent economic down turn. However, proper management of credit default swamps could reduce the moral hazard of the debtor (Senarath & Copp 2015). After applying the business model of proper management of business and gaining sufficient knowledge of the model it helped to mitigate the risk.…”