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Bank Use of Sovereign CDS in the Eurozone Crisis: Hedging and Risk Incentives

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  • Acharya, Viral
  • ,
  • Johnson, Timothy
Abstract
Using a comprehensive dataset from German banks, we document the usage of sovereign credit default swaps (CDS) during the European sovereign debt crisis of 2008-2013. Banks used the sovereign CDS market to extend, rather than hedge, their long exposures to sovereign risk during this period. Lower loan exposure to sovereign risk is associated with greater protection selling in CDS, the effect being weaker when sovereign risk is high. Bank and country risk variables are mostly not associated with protection selling. The findings are driven by the actions of a few non-dealer banks which sold CDS protection aggressively at the onset of the crisis, but started covering their positions at its height while simultaneously shifting their assets towards sovereign bonds and loans. Our findings underscore the importance of accounting for derivatives exposure in building a complete picture and understanding fully the economic drivers of the bank-sovereign nexus of risk

Suggested Citation

  • Acharya, Viral & , & Johnson, Timothy, 2021. "Bank Use of Sovereign CDS in the Eurozone Crisis: Hedging and Risk Incentives," CEPR Discussion Papers 16628, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:16628
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    Cited by:

    1. Czech, Robert, 2021. "Credit default swaps and corporate bond trading," Journal of Financial Intermediation, Elsevier, vol. 48(C).
    2. Gündüz, Yalin, 2018. "Mitigating counterparty risk," Discussion Papers 35/2018, Deutsche Bundesbank.
    3. Marta Gómez-Puig & Simón Sosvilla-Rivero, 2024. "The diabolic loop between sovereign and banking risk in the euro area," IREA Working Papers 202406, University of Barcelona, Research Institute of Applied Economics, revised Feb 2024.
    4. Augustin, Patrick & Sokolovski, Valeri & Subrahmanyam, Marti G. & Tomio, Davide, 2022. "How sovereign is sovereign credit risk? Global prices, local quantities," Journal of Monetary Economics, Elsevier, vol. 131(C), pages 92-111.
    5. Wang, Xinjie & (Ken) Zhong, Zhaodong, 2022. "Post-crisis regulations, market making, and liquidity in over-the-counter markets," Journal of Banking & Finance, Elsevier, vol. 134(C).

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    More about this item

    Keywords

    Credit derivatives; Credit default swaps; Sovereign credit risk; Eurozone; Sovereign debt crisis; Depository trust and clearing corporation (dtcc);
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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