Risk and hedging: Do credit derivatives increase bank risk?

The objective of this paper is to investigate whether financial innovation of credit derivatives makes banks more exposed to credit risk. Although credit derivatives are important for hedging and securitizing credit risk - and thereby likely to enhance the sharing of such risk - some commentators have raised concerns that they may destabilize the banking sector. This paper investigates this issue in a simple model driven by costs of financial distress. The analysis identifies two effects of credit derivatives innovation - they enhance risk sharing as suggested by the hedging argument - but they also make further acquisition of risk more attractive. The latter effect, if dominant, can therefore destabilize the banking sector. The critical factor is, perhaps surprisingly, the competitive nature of the existing underlying credit markets. As these markets become more elastic the threat of destabilization increases. The paper discusses issues related to bank regulation within the context of the model.