Regulation-Induced Financial Innovation: The Case of Credit Default Swaps and Bank Capital

We illustrate how banks use financial innovations to evade regulations in the case of credit default swaps (CDS). We document that the amount of total assets increases after banks begin using CDS, but their risk-weighted assets shrink. Banks use CDS to synthetically shift assets from higher risk-weight categories to the 0%-risk category. As a result, these banks are able to hold less capital, in particular core equity capital, while complying with the requirements of regulatory capital ratios. Our findings suggest that, apart from the risk management motives of using credit derivatives, regulatory capital relief is an important driver for the prolific financial innovations that banks constantly engage in. Such derivatives activities can reduce the effectiveness of bank regulations.