Half-full or Half-empty? Financial Institutions, CDS Use, and Corporate Credit Risk

We construct a novel U.S. data set that matches bank holding company credit default swap (CDS) positions to detailed U.S. credit registry data containing both loan and corporate bond holdings to study the effects of banks' CDS use on corporate credit quality. Banks may use CDS to mitigate agency frictions and not renegotiate loans with solvent but illiquid borrowers resulting in poorer measures of credit risk. Alternatively, banks may lay off the credit risk of high quality borrowers through the CDS market to comply with risk-based capital requirements, which does not impact corporate credit risk. We find new evidence that corporate default probabilities and downgrade likelihoods, if anything, are slightly lower when banks purchase CDS against their borrowers. The results are consistent with banks using CDS to efficiently lay off credit risk rather than inefficiently liquidate firms.