Impact of credit default swaps on financial contagion

Abstract

It had been believed in the conventional practice that the risk of a bank going bankrupt is lessened in a straightforward manner by transferring the risk of loan defaults. But the failure of American International Group in 2008 posed a more complex aspect of financial contagion. This study presents an extension of the asset network systemic risk model (ANWSER) to investigate whether credit default swaps mitigate or intensify the severity of financial contagion. A protection buyer bank transfers the risk of every possible debtor bank default to protection seller banks. The empirical distribution of the number of bank bankruptcies is obtained with the extended model. Systemic capital buffer ratio is calculated from the distribution. The ratio quantifies the effective loss absorbency capability of the entire financial system to force back financial contagion. The key finding is that the leverage ratio is a good estimate of a systemic capital buffer ratio as the backstop of a financial system. The risk transfer from small and medium banks to big banks in an interbank network does not mitigate the severity of financial contagion.