Credit Default Swaps and Bank Regulatory Capital

Review of Finance, forthcoming

50 Pages Posted: 20 Sep 2017 Last revised: 14 Jul 2020

See all articles by Chenyu Shan

Chenyu Shan

Shanghai University of Finance and Economics

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Xing (Alex) Zhou

Board of Governors of the Federal Reserve System

Date Written: June 8, 2020

Abstract

While credit default swaps (CDS) 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.

Keywords: Credit default swaps, CDS, Capital relief, RWA ratio, Bank risk-taking

JEL Classification: G21

Suggested Citation

Shan, Chenyu and Tang, Dragon Yongjun and Yan, Hong and Zhou, Xing (Alex), Credit Default Swaps and Bank Regulatory Capital (June 8, 2020). Review of Finance, forthcoming, Available at SSRN: https://ssrn.com/abstract=3038730 or http://dx.doi.org/10.2139/ssrn.3038730

Chenyu Shan (Contact Author)

Shanghai University of Finance and Economics ( email )

100 Wudong Road
Shanghai
China

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics ( email )

KKL 1004
Pokfulam Road
Pokfulam
Hong Kong
(852)22194321 (Phone)

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Xing (Alex) Zhou

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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