Credit derivatives and loan yields

• Published date: 01 February 2022
• Author: Nimita Azam,Abdullah Mamun,George F. Tannous
• Date: 01 February 2022
• DOI: http://doi.org/10.1111/fire.12285

DOI: 10.1111/fire.12285

ORIGINAL ARTICLE

Credit derivatives and loan yields

Nimita Azam1Abdullah Mamun2George F.Tannous2

1TexasState Auditor’s Office, Austin, Texas,

USA

2Edwards School of Business, University of

Saskatchewan, Saskatoon, Saskatchewan,

Canada

Correspondence

GeorgeF. Tannous,Edwards School of Busi-

ness,University of Saskatchewan, 25 Campus

Drive,Saskatoon, Saskatchewan S7N 5A7,

Canada.

Email:tannous@edwards.usask.ca

Abstract

We compare the loan yields of credit derivative (CRD)active

bank holding companies (BHCs) with the loan yields of CRD

inactive peers over the pre-crisis, crisis (2008–10), and post-

crisis periods. During the post-crisis period, protection pur-

chasers report lower yields than their peers, while sellers

report yields like those reported by their peers. The relation

between the yield and commercial and industrial (C&I) loans

is positive and significant during the pre- and post-crisis peri-

ods, and CRD activities do not affect this relation. CRD activ-

ities are changing the relations between the loan yield and

consumer loans, real estate loans, and securitization.

KEYWORDS

asset sales, credit derivatives,credit risk, loan types, loan yield, secu-

ritization

JEL CLASSIFICATION

G21, M41

1INTRODUCTION

The creation of credit derivatives (CRDs) is considered one of the most significant financial management innovations

in the past 25 years (Greenspan, 2005). As credit risk management tools, CRDs allow banks to initiate loans and then

transfer credit risk to some other party (Bedendo & Bruno, 2012; Bliss et al., 2018; Hakenes& Schnabel, 2010;Hirtle,

2009; Minton et al., 2009). CRDs make it easier for banks to meet capital requirements (Ashraf et al., 2007; Beyhaghi

et al., 2017; Shao & Yeager,2007;Sinkey&Carter,2000),improve liquidity (Bedendo & Bruno, 2012; Beyhaghi et al.,

2017), expandthe supply of loans (Cebenoyan & Strahan, 2004;Hirtle,2009; Minton et al., 2009; Hakenes & Schnabel,

2010;Bedendo & Bruno, 2012), and reduce the price of credit (Cebenoyan& Strahan, 2004;Hirtle,2009;Marsh, 2006;

Norden & Wagner,2008).1

1Previousstudies also suggest that CRDs contribute to the overall market efficiency but there is risk from the proliferation of CRDs. Brief discussions of their

findingsare provided in Section 1of the Online Appendix.

Financial Review. 2022;57:205–241. wileyonlinelibrary.com/journal/fire ©2021 The Eastern Finance Association 205

206 AZAM ET AL.

We examine whether CRDs affect the loan yields of United States (US) bank holding companies (BHCs). The loan

yield is calculated as the interest plus fee income from loans divided bytotal loans. It is a bank-level aggregate measure

effectively equal to the averagecontractual income expected from loans minus the portion of interest and fee income

that remain uncollected due to default. Our objective is to make inferences about whether the utilization of CRDs

changes the averageborrower’s cost per dollar of loans. The loan yield is well suited for our purposes as it is positively

and highly related to the averagecontractual rate on loans so that we may attribute an increase (decrease) in the loan

yield to an increase (decrease) in the average contractual rate on loans.2The loan yield providesa summary of the

return on the entire loan portfolio. Therefore, the effects of CRDs on the loan yield would reflect the combined effect

of CRDs on the loan rate paid by an averagecustomer of a BHC.

Previous studies provide insight regarding the impact of CRDs on the supply of loans (Bedendo & Bruno, 2012;

Hirtle,2009) and the rates on commercial and industrial (C&I) loans (Hirtle, 2009). Yet, there is little empirical evidence

on the impact of CRDs on the loan yield of BHCs. Our paper is an attempt to address some open questions. How does

the utilization of CRDs affect the loan yield? How would the effects of CRDs on the loan yield during the yearsafter the

2008–2009 crisis compare with the effects during the pre-crisis and crisis periods? What are the effects of asset sales

and securitization (AS&S) on the loan yield? Does the utilization of CRDs change these relations? Does the utilization

of CRDs change the relations between loan types and the yield on loans? The answers to these questions haverelevant

policy and practical implications.

First, whether the use ofC RDs benefitsthe average BHC’s customer through lower loan yield is a relevant question,

giventhe ample literature which argues that CRDs may not be beneficial to financial institutions (Duffee & Zhou, 2001;

Instefjord, 2005; Morrison, 2005;Wagner,2007). Further, the improper use of CRDs may have contributed to the

2008–2009 financial crisis (Mayordomo et al., 2014; Minton et al., 2009). Hirtle (2009) finds that CRDs may lead a

BHC to increase the supply of credit to a particular category of customers, but the increase comes at higher rates.

Thus, CRDs may not benefit borrowers.

Second, the way in which the effects of CRDs vary across various economic conditions is of interest to policy mak-

ers. Using a sample of US bank data between 1997 and 2006, Hirtle (2009) finds that CRDs expand the volume of

credit to C&I term borrowers that are likely to be “named credits,” but the expansion comes at higher rates.The evi-

dence related to other categories of C&I loans is mixed. In contrast, Bedendo and Bruno (2012) find that during the

2007–2009 years the amount of net credit insurance purchased (protection purchased minus protection sold) has no

effect on the supply of loans and CRDs replaced AS&S in managing credit risk. Yet, it remains unknown whether the

effects of CRDs on the loan yield and AS&S during the post 2008–2009 crisis period are different from the effects

before and during the crisis. This information is important given the significant regulatory changes that were intro-

duced after the crisis to regulate the CRD market (Aldasoro & Ehlers, 2018; Loon & Zhong, 2014). Based on European

bank data, Titova et al. (2020) report that using hedging derivatives efficiently during the 2008–2009 crisis resulted

in lower volatility of bank stock returns and higher values, but this relationship becomes less pronounced or reversed

in the post-crisis period.

Our research advances the literature along four dimensions. First, studying the impact of CRDs on the loan yield

supplements the research of Hirtle (2009), Bedendo and Bruno (2012), and Shao and Yeager (2007). Hirtle analyzes

the changes in the volume of new C&I loans as a bank purchases more credit risk protection. Hirtle finds that CRDs

expand the volume of credit to C&I term borrower that are likely to be “named credits”, but the expansion comes at

higher rates. The evidence related to other categories of C&I loans is mixed. Bedendo and Bruno (2012) examinethe

impact of CRDs on the supply of various classifications of loans (1–4 mortgages, other mortgages, C&I loans, and con-

sumer loans) and on the risk of banks during the 2007–2009 period. They find that the amount of net credit insurance

purchased (protection purchased minus protection sold) does not have a significant direct impact on the supply of

2Another interesting variable is the net loan yield defined as the loan yield minus net charge-offs (loan charge-offs minus recoveries)divided by total loans.

However,the net loan yield is further away from the average contractual loan rate and, may be subject to errors that are not random given that charge-offs

andrecoveries may be used by banks for income smoothing (Beck & Narayanamoorthy, 2013;Liu&Ryan,2006). Therefore, the changes in the loan yield are

moreaccurate proxies of the changes in the average contractual loan rate than the changes in the net loan yield.

AZAM ET AL.207

credit. Shao and Yeager(2007) investigate how CRDs affect the return on assets (ROA), operating income, and stock

returns. They find that users of CRDs, mainly protection purchasers and activeusers but not protection sellers, report

lowerreturn measures. Inthis study, we analyze how the utilization of CRDs affects the loan yield, which is a bank-level

aggregate measure of the average return on the loan portfolio. Fromthis analysis, we learn whether the use of CRDs

benefits the average BHC’s customer through lower loan yield. Hirtle’sresults regarding the impact of CRDs on C&I

loans, cannot be generalized to the entire loan portfolio. The results providedby Bedendo and Bruno (2012) regarding

the supply of loans do not indicate what happens to the averageloan rate. And lastly, the return measures analyzed by

Shao and Yeagerare not good proxies for the average loan rate.

Second, we investigate whether the effects of CRDs on the loan yield, AS&S, and loan types during the post 2008–

2009 financial crisis period differ from the effects before and during the crisis. The differences are open questions,

while there is ample evidence suggesting significant changes in the use of CRDs and the regulatory environment. The

pre-crisis period witnessed significant activities in subprime lending and higher credit risk taking by banks (Bedendo

& Bruno, 2012; Purnanandam, 2011). Purchases of credit protection aimed mainly at preserving adequate levels of

regulatory capital in response to capital shocks (Bedendo & Bruno, 2012). During the crisis, uncertainty regarding the

value of bank assets significantly increased, which made AS&S of business loans very expensive or unfeasible while

the market for credit derivative products remained liquid. As a result, there was a shift from AS&S to CRDs and the

increase in net protection purchased largely followed an increase in the proportion of C&I loans (Bedendo & Bruno,

2012). After the crisis, the underlying credit risks shifted towards sovereigns and portfolios of underlying reference

securities that had better credit ratings (Aldasoro & Ehlers, 2018; Loon & Zhong, 2014).

In terms of regulatory interventions, during the pre-crisis period, regulators rushed to approve emergency mea-

sures to preserve sufficient liquidity in the AS&S market (Adrian & Shin, 2010). These measures were justified on

the basis that AS&S would broaden the funding sources of BHCs and increase the supply of credit at a time when

most short-term funding channels had frozen (Brunnermeier, 2009). During the crisis, the Government introduced

the Troubled Asset Relief Program(TARP) and urged the recipient banks to lend the new capital but warned against

taking credit risks with TARPmoney (Cocheo, 2008). After the crisis, the Dodd-Frank act increased over-the-counter

transaction costs which resulted in a decrease in liquidity in the credit default swaps market (Loon & Zhong, 2014).

Furthermore,standardization of contracts, expanded reporting requirements, mandatory central clearing, and margin

requirements, were introduced for a wide range of derivatives which contributed to the drop in CRD activities (Alda-

soro & Ehlers, 2018; Financial Stability Board, 2017; Loon & Zhong, 2014).

Third, we investigate whether CRDs affect the utilization of AS&S as credit risk management tools. Like CRDs,

asset sales allow BHCs to initiate loans and then transfer credit risk to other parties. They make it easier for banks

to meet capital requirements, improve liquidity, expand the supply of loans, and reduce the price of credit to bor-

rowers (Bedendo & Bruno, 2012;Casuetal.,2011; Cebenoyan & Strahan, 2004; Hakenes & Schnabel, 2010;Hirtle,

2009; Loutiskina, 2011; Minton et al., 2009). CRDs and asset sales may be used separately or jointly for risk transfer,

but there are exceptions. Banks favorasset sales when loans are risky (Parlour & Winton, 2013) but they favor CRDs

when there is an ongoing relationship between the lender and the borrower (Beyhaghi et al., 2017). Banks also pre-

fer CRDs in competitive markets when information about the target loans is publicly available (Hakenes & Schnabel,

2010). Overall, the results of these studies suggest that the CRD activities by a bank may reduce or leavethe bank’s

activities unchanged in asset sales. However,CRDs and asset sales have different effects on the loan yield. For exam-

ple, if a BHC sells a high-risk high-yield loan the result would be a decrease in the loan yield. If a CRD instrument is

used, no decrease in the loan yield would be observed as the BHC would hedge the high risk and keepthe high yield.

Securitization involves securitizing an asset and then selling the securities or a portion of them in the marketwith

or without recourse. If there is no recourse, securitization is similar to asset sales suggesting that CRDs would weaken

or leave unchanged the relation between securitization and the loan yield. If there is recourse, Casu et al. (2011)sug-

gest that securitization may be viewed as a financing rather than a risk management mechanism. They propose that

recourse alters the risk-taking appetite of the issuing banks across asset classes. Therefore, the net impact of securi-

tization on the risk-taking behavior of issuing banks is ambiguous and depends on the structure of the transactions.