Abstract
Credit derivatives in the form of credit default swaps (CDS) are recognized by Basel II and Basel III as a tool for managing bank regulatory capital requirements. We find that banks become more aggressive in risk taking after they begin using credit derivatives. This increase in bank risk is linked to banks’ CDS trading. Loans issued to CDS-referenced borrowers are larger and have higher yield spreads if the lead banks in the syndicate are active in CDS trading. During the 2007-2009 credit crisis, banks with large positions in credit derivatives at the onset of the crisis raised more capital, reduced lending more, and experienced larger stock price drops than CDS-inactive banks. Although they take more risks, CDS-active banks have better operating and financial performance during normal times.
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