Discussion paper

DP16628 Bank Use of Sovereign CDS in the Eurozone Crisis: Hedging and Risk Incentives

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

£6.00
Citation

Acharya, V, and T Johnson (eds) (2021), “DP16628 Bank Use of Sovereign CDS in the Eurozone Crisis: Hedging and Risk Incentives”, CEPR Press Discussion Paper No. 16628. https://cepr.org/publications/dp16628