How Did Banks Deal with Credit Derivatives during the Financial Crisis?
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Date
2012-06
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The Ohio State University
Abstract
Many observers argue that credit derivatives played a big role in the recent financial crisis. Alan S. Blinder, the Gordon S. Rentschler Memorial Professor of Economics and Public Affairs at Princeton University, regards “wild derivatives” as the first error leading to the financial crisis. David Paul, the president of the Fiscal Strategies Group, concludes that without credit default swaps, AIG would still be in business. While many studies have analyzed the benefits and risks of credit derivatives and the role they played during the financial crisis, there is only limited research about how banks dealt with their credit derivatives during the toughest time of financial crisis. With data collected from the Consolidated Financial Statements for BHCs (FR Y-9C), I conclude that the notional amounts of credit derivatives held by banks boomed in 2006 and 2007 but reduced sharply in 2008 and 2009. I believe that the plunge in notional amounts is due to the counterparty credit risk. Then, I use the Herfindahl–Hirschman Index to calculate the concentration level of credit derivatives positions in the banking sector, and I find out that the credit derivatives positions were highly concentrated during the financial crisis. I also briefly review the significant events that happened in 2008 and summarize the role that credit derivatives played in these events. Finally, I discover that JP Morgan Chase, Bank of America and Citigroup were the major users of credit derivatives in 2006-2010. Most of their positions were used for trading, but they did use credit derivatives for hedging their own portfolios. They largely matched their bought and sold protections and took the counterparty credit risk into consideration.
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Keywords
bank, credit derivative, financial crisis, counterparty credit risk