In essence, the CDS protection is not really being used to insure against default but to reduce market price volatility. Let us now turn to a second example of a bank hedging its corporate lending. Banks lend to a broad range of companies. In many cases they would be expected to hold these loans on their books until maturity (as opposed to selling them off to other investors). In order to reduce its measured outstanding credit risk, a bank may choose to purchase off-setting CDS protection, probably on a portfolio of loans. By so doing, the bank can make greater use of its internal credit risk limits and may get regulatory capital relief. In most cases, another leveraged market participant (bank or hedge fund) would write the CDS. (In some cases the insurance provider may be an unlevered institution, for which most of the concerns below would be reduced.) In the first example, the pension fund was concerned about short-term price swings. In this second example, the bank should be concerned to protect itself against clusters of defaults. But if the risk management of the ensuing portfolio of loans and CDS is not done with serious attention paid to the joint risk profile of the corporate borrowers and the providers of the CDS protection, the true net risk position might be worse than it appears. That could fool regulators as well as the bank’s own risk management function.
We believe that it is better to have a collection of ex ante determined stress scenarios that illustrate banks’ potential weaknesses publicly, even if the actual regulatory capital is not sufficient in all those scenarios. In other words, stress tests should not always be a check list “pass” or “fail” (after all, to make a bank fail or pass a stress test is just a question of scaling the test). Comparable, tail event stress tests could be an important piece in the information set that investors and regulators analyse to determine the relative value and risk profile of the institution. The second set of examples above illustrated that contract design features which are exclusively relevant in the extreme tails are perhaps best avoided. The reason is simply that such features, which do not seem to matter in most states of the world, end up being treated  15  How many “once-in-a-lifetime” events happen to us every year? BIS central bankers’ speeches  9  as if they will never matter. In other words, market participants need to make sure that an exercise of an option is seen as just that, a normal exercise of an option. No more and no less. Sophisticated market participants should not be genuinely surprised (or feign surprise) by another market participant trying to optimise its behaviour consistent with a contract. The implications of a contract should be clear and the structures should be as transparent as possible.