Although there is a sizable literature demonstrating that liquidity and transaction costs are multidimensional, researchers continue to estimate adverse-selection costs using only prices. We present a model of a profit-maximizing specialist who posts prices and depths. The model is simulated to measure changes in the adverse-selection component of the spread that result under different levels of informed trading. We find that spread decompositions fail to capture the full extent of adverse-selection risk when specialists choose depth. We recommend that researchers use adverse-selection measures that account for depth as well as spread to mitigate this problem. 2006 The Southern Finance Association and the Southwestern Finance Association.

We use unique data from U.S. bank holding company-affiliated securities dealers to study the use of collateral in bilateral repurchase and securities lending agreements. Market participants' use of collateral differs substantially across asset classes: for U.S. Treasury securities transactions, we find that haircuts are large enough to provide full protection from default, whereas the same is not usually true for equities transactions. Further, although most of the equities in our sample are each associated with a unique haircut, most of the U.S. Treasury securities are each associated with more than one haircut. We relate these findings to implications of the zero value-at-risk feature that can be found in theories of collateral as an enforcement mechanism, and show that the data do not confirm these implications. We then turn to models of adverse selection that predict a negative relationship between haircuts and interest rates, based on the use of collateral as a screening mechanism. We find this negative relationship only for those trades in which the securities dealers are receiving U.S. Treasury securities and delivering cash.

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This note uses a unique dataset that matches banks' securities and loan portfolios to bank credit derivative transactions to characterize the basic features of how the largest banks in the U.S. use the single name CDS market in their investment portfolios.

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We construct a novel U.S. data set that matches bank holding company credit default swap (CDS) positions to detailed U.S. credit registry data containing both loan and corporate bond holdings to study the effects of banks' CDS use on corporate credit quality. Banks may use CDS to mitigate agency frictions and not renegotiate loans with solvent but illiquid borrowers resulting in poorer measures of credit risk. Alternatively, banks may lay off the credit risk of high quality borrowers through the CDS market to comply with riskbased capital requirements, which does not impact corporate credit risk. We find new evidence that corporate default probabilities and downgrade likelihoods, if anything, are slightly lower when banks purchase CDS against their borrowers. The results are consistent with banks using CDS to efficiently lay off credit risk rather than inefficiently liquidate firms.

This Working Paper should not be reported as representing the views of the IMF.