Review of Finance Vol. 25 No. 1 2021

Credit Default Swaps and Bank Regulatory Capital

Chenyu Shan¹; Dragon Yongjun Tang²; Hong Yan³; Xing Zhou⁴

¹ Shanghai University of Finance and Economics · ² The University of Hong Kong · ³ Shanghai Advanced Institute of Finance, SJTU · ⁴ Federal Reserve Board of Governors

Abstract

While credit default swaps (CDSs) can be used to hedge credit risk exposures or to speculate, we examine another use of them: banks buy CDS referencing their borrowers to obtain regulatory capital relief. Such capital relief activities have unintended consequences, as banks extend riskier loans when they buy CDS to boost capital ratios. While capital-induced CDS-user banks achieve higher profitability during normal times, they perform worse and request more government support in crisis periods than other banks that use CDS for trading or speculation. Our findings suggest that banks’ CDS trading for capital relief purposes may make these banks riskier.

DOI

10.1093/rof/rfaa021

Volume

25

Issue

1

Pages

121-152

Language

en

Sources

bibtex:phds-export.bib openalex crossref

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