Working Paper: CEPR ID: DP16628
Authors: Viral Acharya; Yalin Gündüz; Tim Johnson
Abstract: Using a comprehensive dataset from German banks, we document the usage ofsovereign credit default swaps (CDS) during the European sovereign debt crisis of2008-2013. Banks used the sovereign CDS market to extend, rather than hedge,their long exposures to sovereign risk during this period. Lower loan exposure tosovereign risk is associated with greater protection selling in CDS, the effect beingweaker when sovereign risk is high. Bank and country risk variables are mostlynot associated with protection selling. The findings are driven by the actions ofa few non-dealer banks which sold CDS protection aggressively at the onset ofthe crisis, but started covering their positions at its height while simultaneouslyshifting their assets towards sovereign bonds and loans. Our findings underscorethe importance of accounting for derivatives exposure in building a complete pictureand understanding fully the economic drivers of the bank-sovereign nexus of risk
Keywords: credit derivatives; credit default swaps; sovereign credit risk; eurozone sovereign debt crisis; depository trust and clearing corporation (DTCC)
JEL Codes: G01; G15; G21; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Sovereign risk (F34) | Banks' trading behavior (G21) |
| Risk-weighted assets (RWA) ratio (G32) | Banks' trading behavior (G21) |
| Lower loan exposure to sovereign risk (F34) | Greater protection selling in cds (G19) |
| Sovereign risk high (F34) | Weaker portfolio substitution effect (D11) |
| Deposit inflows during the crisis (F65) | Banks selling more risky sovereign protection (F65) |
| Banks' own cds spreads (G21) | Protection selling (D18) |