Credit Risk Transfer Activities and Systemic Risk: How Banks Became Less Risky Individually But Posed Greater Risks to the Financial System at the Same Time

Abstract

A main cause of the ongoing financial crisis is the various ways through which banks have transferred credit risk in the financial system. In this paper we study the riskiness of banks that have used these methods, as perceived by the market. For this we analyze a sample of banks that trade Credit Default Swaps (CDS) and a sample of banks that issued Collateralized Loan Obligations (CLOs) between 1997 and 2006. We find that after their first usage of either risk transfer method, these banks experience a large and significant permanent increase in their share price beta. This suggests that the market was aware of the risks arising from these methods, long before the actual onset of the crisis. We also address the question of the source of the beta effect by separating it into a volatility and a market correlation component. Quite strikingly we find that the increase in the beta is solely due to an increase in banks' correlations. The volatility of these banks' returns actually declines. This suggests that banks undertaking credit risk transfer activities may appear individually less risky, while actually posing a greater risk for the financial system. We argue that this posits a challenge for financial regulation, which has typically focused on the level of the individual institution.