Implications of Credit Trading for the Risks of Banks
One of the biggest trends of the past fifteen years has been the emergence of credit trading. The common view, to which I generally subscribe, is that this has made individual banks and the banking system as a whole safer. Certainly the dot com implosion in 2001 and 2002 had a remarkably modest impact by historical standards. I recall no serious concern about a major bank failing during that period, whereas such concerns often surfaced in past severe credit cycles even if they rarely came to pass.
A lingering concern is whether the credit trading/credit derivative market itself is robust enough to function smoothly in a severe downturn. Will the apparently greater diversification of credit risk created by an originate-and-distribute approach to the banking business continue to function smoothly under stress? Regulatory concern about sloppy operational processes in the credit derivative market is largely motivated by its importance for stability of the banking system as a whole.
Clearly there is no definitive answer as to how serious a risk is implicit in the operational fabric of the credit derivatives market. Nevertheless, I am interested in your views on how much progress has been made since regulators began emphasizing the issue. If you know of formal studies that have attempted to assess the impact of credit trading on systemic risk of the banking system, these also would be interesting.