Should Banks Trade Equity Derivatives to Manage Credit Risk?

Banks incur a variety of risks and utilise different techniques to manage the exposures so created. Some of those techniques are internal to the bank. For example, the law of large numbers enables banks to diversify away liquidity risk or default risk from a portfolio of retail loans. Alternatively, matching of asset and liability characteristics such as interest rate reset dates removes interest rate risk. Other techniques involve use of markets. For example, banks can take positions in markets in interest rate options and futures to manage interest rate risk. Unfortunately, one type of exposure does not appear amenable to either of these risk management techniques. This is the credit risk arising from loans extended to large corporate customers. While a portfolio of corporate loans can provide some protection by diversification, most banks face significant residual exposure to large corporate customers. Nor does it seem generally possibl