Impact of credit default swaps on financial contagion

Abstract

Abstract-It had been believed in the conventional practice that the risk of a bank going bankrupt is lessened in a straightforward manner by transferring the risk of loan defaults. But the failure of American International Group in 2008 posed a more complex aspect of financial contagion. This study presents an extension of the asset network systemic risk model (ANWSER) to investigate whether credit default swaps mitigate or intensify the severity of financial contagion. A protection buyer bank transfers the risk of every possible debtor bank default to protection seller banks. The empirical distribution of the number of bank bankruptcies is obtained with the extended model. Systemic capital buffer ratio is calculated from the distribution. The ratio quantifies the effective loss absorbency capability of the entire financial system to force back financial contagion. The key finding is that the leverage ratio is a good estimate of a systemic capital buffer ratio as the backstop of a financial system. The risk transfer from small and medium banks to big banks in an interbank network does not mitigate the severity of financial contagion.

Simulating Fire-Sales in a Banking and Shadow Banking System

“…The presence of shadow banks in the financial markets seemed to be one of the biggest issues that undermined the effectiveness of these regulatory measures (Pozsar et al, 2010). Therefore, since the shadow banking system has rapidly grown after the year 2000, many studies tried to include shadow banks into the analysis of the wider financial panorama, to explore the interactions between the two systems, inspect the systemic risk implications (Maeno et al, 2014;Luttrell et al, 2012) and look for potential regulation solutions (Schwarcz, 2012). Plantin (2014) studies the optimal prudential policies of banks in presence of a shadow banking sector.…”