The effect of financial innovation on European banks' risk

This study examines the effect of the use of securitization and credit derivatives on the risk profile of European banks. Using information from 134 listed European banks during the period of 2006-2010, the results show that securitization and trading with credit derivatives have a negative effect on financial stability. The main findings also show the dominance of trading positions over hedging positions for credit derivatives. The results of this study support the higher capital requirements of the new Basel III international banking regulations. Furthermore, accounting measures do not readily indicate market risks, and thus the results support central banks' use of market-solvency measures to monitor financial stability.