An examination of bank use of credit derivatives to mitigate risk: an empirical analysis of its potency and impact on bank portfolio management and performance.

Abstract

This study examines what drives the risk appetite of US banks to use credit derivatives to mitigate risk, the potency and impact of the instruments on bank portfolio management and performance. Panel data covering the period of 2002 to 2011 was employed and segmented into three phases (pre-crisis, crisis and post-crisis). The techniques used for analysis were Random Effects Logistic Regression and Arellano-Bond Dynamic Data Generalised Method of Moments. Findings showed that during the pre-crisis period, banks used the instruments more for trading than for hedging, expanding their level of risk taking. The use of the instruments was subdued during the crisis period, and was used more for hedging purposes due to the heightened state of uncertainties, anxieties and shocks. For post-crisis, banks returned to their trading rather than hedging to improve profitability. Further findings revealed that pre-crisis, the connection between the employment, application of credit derivatives and bank portfolio performance was generally significant as banks with credit derivatives activities outperformed other banks. At the full length of the crisis period, banks restructured their portfolios to reflect asset write-downs and a subdued demand for the instruments thus affecting portfolio returns significantly. Post-crisis period saw the gradual responses to the reforms in the market place though returns were not at the level of the pre-crisis period as everything was still in a wobbling mode. Furthermore, moral hazard was also identified as one of the reasons for the lapses which led to the crisis and thus bank portfolio performance. This study concludes that credit derivatives do affect bank portfolio persistence, risk and return for the three periods whether in a capacity of a beneficiary or as a guarantor. Banks would need to re-examine their instruments to get them on a sustainable path as well as attract portfolio flows and growth.