Half-full or Half-empty? Financial Institutions, CDS Use, and Corporate Credit Risk

Abstract

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.

Identifying Empty Creditors with a Shock and Micro-Data

“…Subrahmanyam et al (2014) show in a large sample of distressed and healthy firms that the introduction of CDS increases the probability of bankruptcy. However, Caglio, Darst, and Parolin (2018) find that CDS hedging by a firm's creditors may in fact decrease the probability of default of these firms. Using a small sample of distressed companies, Bedendo, Cathcart, and El-Jahel (2016) find that CDS do not have a significant effect on the likelihood of bankruptcy.…”

Do Character, Capacity, Capital, Collateral, and Conditions as Affect on Bad Loans

“…So, the better the ability of customers to manage their business, the bad loans will decrease. This aspect can also be seen in customer business financial variables, such as leverage, equity volatility, profitability, cash-to-assets ratio, and business size (Caglio, Darst, & Parolin, 2019). Mukhsinati (2011) found a negative relationship between Capacity and bad loans.…”