The Bank for International Settlements and Credit Default Swaps
Located in Basel, Switzerland, the Bank for International Settlements (BIS) is an institution that lends its expertise to central banks worldwide. Its aims are to promote monetary and financial stability globally. This is accomplished by serving as a bank for central banks, fostering international cooperation in these areas, and acting as a hub for central banks to exchange information and collaborate on policy issues.
The Bank for International Settlements
One of the crucial financial tools that banks use today are Credit Default Swaps (CDSs), which are essentially a form of insurance against the default of a borrower. Banks use these financial derivatives to hedge their risk exposure to certain types of loans, thereby offsetting potential losses they may incur should a borrower default.
Impact of CDSs on Counter-Cyclical Capital Buffer
However, according to a recent working paper published by the BIS, the usage of these CDSs may have unintended consequences on the efficacy of certain macro-prudential policies, particularly the counter-cyclical capital buffer (CCyB).
The CCyB is a macro-prudential regulation aimed at ensuring banks build up capital reserves during periods of high credit growth, which can be used to absorb losses during downturns. The goal is to make banks more resilient and reduce the pro-cyclicality of the financial system.
The Uninsured Loan Ratio
The BIS paper, published on January 20, utilizes regulatory data from the European Union to examine banks’ CDS positions, allowing the authors to measure the “uninsured loan ratio”—a metric that quantifies how much of a bank’s lending is unhedged by CDSs. The authors found that this ratio shifts with changes in the CCyB, suggesting that CDS usage can potentially weaken the transmission of macro-prudential policy.
Implications for Macro-Prudential Policy
This finding has significant implications. It suggests that while banks may be using CDSs to manage their risk exposures and protect against potential losses, this could inadvertently undermine the effectiveness of macro-prudential policies designed to ensure the stability of the financial system. As such, regulators and policymakers may need to consider this dynamic when designing and implementing such policies.
These insights underscore the importance of understanding the complex interactions between financial derivatives, such as CDSs, and macro-prudential policy measures, such as the CCyB. This understanding can help to ensure that these policies achieve their intended objectives and contribute to the overall stability of the financial system.
For more details, you can access the full BIS paper Here.
