Research Program in Finance Working Paper RPF-289 Credit Derivatives in Banking: Useful Tools for Managing Risk?

We model the effects on banks of the introduction of a market for credit derivatives; in particular, credit-default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans trigger the bank’s financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools such as loan sales without recourse, these instruments make it easier for banks to circumvent the “lemons ” problem caused by banks ’ superior information about the credit quality of their loans. However, we find that the introduction of a credit-derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down