Minton, Stulz find credit derivatives can potentially upset banks' earnings

Since 2001, a small number of American banks have fueled a significant increase in credit default swaps as a way to provide credit protection to hedge risks. However, new research from two Fisher finance professors find that many big name banks steer away from hedging credit risks because they potentially increase the volatility of their earnings.

Fisher finance professors and co-authors of the study Bernadette Minton and René Stulz found that in 2005 the use of credit derivatives was limited to just 23 out of 395 banks because of adverse selection, moral hazards and the inability of banks to use hedge accounting when hedging with credit derivatives. Minton recently presented the paper at a conference on risk management at the Federal Reserve Bank of Chicago.

The researchers, who co-authored the paper along with Fisher alumnus and Georgetown University faculty member Rohan Williamson, examined 2005 fiscal year-end disclosures from 395 domestically-owned bank holding companies with more than $1 billion in assets. Growth in credit default swaps jumped from $698 billion in June 2001 to more than $42.5 trillion by June 2007. They find that usage of credit derivatives is not widespread among banks. Typically, about 20 bank holding companies use credit derivatives in their sample.

Larger banks such as JPMorganChase and Bank of America bought and sold a combined $4.2 trillion in 2005, which exceeded the total notional amount of $1.2 trillion in derivatives bought and sold by all other banks examined as a part of the study.

According to the disclosures, the researchers found that the banks typically used credit derivatives for a variety of reasons including hedging the credit risk of their loan portfolio and in their role as financial intermediaries. However, the extent of use of derivatives to hedge seems quite limited. In 2005, the authors find that the banks overall used the credit derivatives to hedge less than two percent of their loans. The evidence shows that the main use of credit derivatives by banks is in their role as dealers rather than for hedging bank loans.

“Since credit derivatives are used only to a very limited extent to hedge loans, they can only make banks and the financial system sounder if they create few risks for banks when the banks take positions in them for other reasons than to hedge loans,” Minton said.

Banks with commercial and industrial loans and less capital are more likely to be net buyers of credit protection, while institutions with more capital, higher profits and more agricultural loans were less likely to buy credit protection.