Do banks use credit default swaps to hedge or speculate? An agency theoretic perspective

Abstract

The global financial crisis (GFC) has drawn attention to the increased risk taking of financial institutions, in particular risk taking by banks. Some observers have also suggested that credit default swaps (CDS) have not only contributed to the GFC but to some extent have also exacerbated it. Moreover, it would seem that in many cases the main motivation for banks in using CDS is for trading purposes (Fitch Ratings, 2007, 2010). Given that banks are among the most important sources of finance, and are fraught with extensive public exposure through deposits, risk taking in banks is an important consideration for both regulators and the general public. This paper explores an agency theoretic perspective in analysing the potential motivations for risk taking vs. risk aversion decisions within banks. The paper asserts that the use of CDS for speculative/trading purpose indicates a risk taking motive, whereas the use of CDS for hedging purposes suggests that the overriding motivation is risk aversion. We argue that these dichotomous themes can explain banking strategy in the use of CDS and in turn can also explain the rationale for the phenomenal growth in CDS up until the onset of the GFC.