CREDIT DERIVATIVES IN BANKING: BENEFITS AND THREATS

Abstract

Financial institutions have faced a variety of threats, the main reasons for which are weak lending standards, ineffective risk evaluation of the loan portfolio, lack of attention to economic and other factors that can affect the creditworthiness of bank counterparties. Thus, among various threats, credit risk, caused by lending, remains the main source of problems for commercial banks. However, globalization and liberalization of the global financial system has led to the appearance of other sources, including trade and investment transactions, which are reflected both on the balance sheet and off-balance sheet. Banks are increasingly faced with credit risk in other financial operations – for example, with derivative financial instruments.

Effective credit risk management is a critically important component of the comprehensive approach to risk management and the long-term success of a banking organization. The use of financial instruments that allows commercial banks to transfer credit risk to a third party for a fee and, thus, avoid the additional costs for forming reserves, has become one of the ways to prevent negative consequences. However, despite the many advantages associated with the risk hedging, credit derivatives, like other financial innovations, pose additional risks directly related to the application of these instruments. For example, these risks have manifested themselves in the global financial crisis of 2008-2009 and minimized the positive effect of the credit derivatives.

This article discusses the advantages and disadvantages of using credit derivatives by commercial banks, shows the need for timely identification of probable risks and the development of effective methods for managing them by both the risk management of the bank and regulators.