How Do Large Banks Use Credit Default Swaps to Manage Risks? The Bank-Firm Level Evidence

Dealing with dealers: Sovereign CDS comovements

“…and Lando (2014), Hasan and Wu (2016), Shan, Tang, and Yan (2016), and Augustin, Sokolovski, Subrahmanyam, and Tomio (2017). 22,23 There are additional frictions and features of the sovereign CDS market that could help explain the role of common quotes from dealers facing buying pressure.…”

“…Our instrumental variable proxies a demand shock on the sovereign CDS to hedge the credit exposures of the largest and global active banks where improvements of the average Tier 1 capital ratio are related to an efficient use of sovereign CDS. The motivation for the use of this instrumental variable relies on Yorulmazer (2013), Hasan and Wu (2016), Shan, Tang, and Yan (2016), and Augustin, Sokolovski, Subrahmanyam, and Tomio (2017) evidence about the use of CDS by banks to reduce the capital requirements for existing exposures (see also ECB, 2009). 29…”

“…Thus, they are able to hold less capital while complying with the requirements of regulatory capital ratios. Hasan and Wu (2016) test five hypotheses on whether banks use CDS to hedge corporate loans, provide credit enhancements, obtain regulatory capital relief, and exploit banking relationship and private information. They find strong evidence for the credit enhancement and regulatory capital relief hypotheses.…”

“…We posit that the mechanism causing the CDS excess correlation is the buying pressure faced by CDS dealers. Specifically, we conjecture that the common demand on a given pair of sovereign CDS is explained by the dealers' urgency to buy protection in order to mitigate the credit risk in their portfolios and/or to lower regulatory capital requirements, especially in banks (Yorulmazer, 2013;Klingler and Lando, 2014;Hasan and Wu, 2016;Shan, Tang, and Yan, 2016;and Augustin, Sokolovski, Subrahmanyam, and Tomio, 2017).…”

“…Additionally, when a bank acquires a CDS against a risky investment, the bank can hold less capital against such investment. In particular, Hasan and Wu (2016) document that, among the potential uses of CDS by banks, they principally use CDS because of their benefits in terms of capital reliefs and credit enhancement. In fact, as stated by Yorulmazer (2013), AIG claimed that 72% of the notional amounts of CDS sold by AIG as of December 2007 were used by European and other banks for capital relief purposes.…”