Half-full or half-empty? Financial institutions, CDS use, and corporate credit risk

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 riskbased 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.

Risk-Taking and Monetary Policy Transmission: Evidence from Loans to Smes and Large Firms

“…Figure 3 shows the average 8 Our paper also contributes to a growing literature using the FR Y-14 data. The data is used to study the impact of CDS use by banks on borrower credit risk (Caglio, Darst, and Parolin, 2019), the relationship between U.S. exchange rates and banks credit supply to foreign firms (Niepmann and Schmidt-Eisenlohr, 2018), how banks re-balance their portfolios due to losses (Bidder, Krainer, and Shapiro, 2018), how monetary policy transmits differently through credit lines versus terms loans during COVID-19 shock (Greenwald, Krainer, and Paul, 2020;Chodorow-Reich, Darmouni, Luck, and Plosser, 2020), the effect of corporate taxes on leverage (Ivanov, Pettit, and Whited, 2020), estimating the value of collateral in new loan originations (Luck and Santos, 2019), and the real effects of quantitative easing (Luck and Zimmermann, 2020), among others.…”

Identifying Empty Creditors with a Shock and Micro-Data

“…Danis (2016) contributes to this debate by providing further evidence that empty creditors have a negative effect on out-of-court debt restructuring. Caglio, Darst, and Parolin (2019) employ granular data on US banks' CDS trading and lending behaviour to investigate the joint effect of the commitment effect and the empty creditor effect. The authors investigate the effect of banks' CDS trading on their borrowers' probabilities of default at both the extensive margin (existence of CDS trading on a firm) and the intensive margin (the hedging behaviour of a firm's lenders).…”

Credit Default Swaps Around the World

“…Narayanan and Uzmanoglu (2018) show that firm value declines as a result of increased costs of capital and lower credit quality when CDS are initiated. In contrast, Caglio, Darst, and Parolin (2019) employ transaction-level data to build a new aggregate measure of CDS use and find that CDS positions of the largest U.S. banks do not adversely affect borrower credit risk, even for lenders that overinsure against credit losses. Bedendo, Cathcart, and El-Jahel (2016) do not find an association between CDS and credit deterioration, and Chakraborty, Chava, and Ganduri (2015) show that CDS firms do not go bankrupt at a higher rate.…”