Credit Derivatives and Bank Credit Supply

Abstract

Our paper explores the influence of credit derivatives on bank credit supply theoretically and empirically. We build a two-stage model of financial intermediation, which treats the bank under consideration as one of a large number of monopolists in the local credit market. From the theoretical model, we derive that there is the positive effect of derivatives position on the loan volume in the risk-neutral bank using the credit derivatives to hedge its credit risk. In the empirical section, we use Bayesian Vector Autoregression (BVAR) model with the U.S. quarterly macro and market data over the period from 1997 to the first quarter of 2014 covering the normal and crisis times. Based on techniques commonly used in the BVAR literature, the empirical results are consistent with prediction by the theoretical model. The Granger-causality test shows that credit derivatives position has one directional Granger causality with bank credit volume at 5% confidence level. The generalized impulse response function suggests that the derivatives position has a persistently positive effect on bank credit supply. Furthermore, the variance decomposition indicates that the derivatives position accounts for over 30 percent of variations in bank credit supply in the long run.