In the banking industry, credit risks are difficult to address or manage, and financial institutions need to separate these risks from other types of critical situations that require insurance. The purchase of such derivatives as credit default swaps (CDS) is often viewed today as an appropriate strategy to reduce potential credit risks (Augustin et al. 176). Citigroup Inc. is one of the largest U.S. banks in which risk management strategy is based on using credit derivatives (Voegeli and Griffin).
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The purpose of this case study is to analyze Citigroup’s approaches to minimizing or hedging credit risks with the focus on assessing the associated threats and possible advantages or disadvantages for other parties that participate in the agreement.
Background Information and Case Details
Citigroup is the U.S. bank that is famous for its active use of derivatives to manage credit risks. In August 2016, Bloomberg and other media reported that Citigroup planned to buy credit default swaps of Credit Suisse Group, a financial services company that is headquartered in Zürich, Switzerland (Voegeli and Griffin). According to Voegeli and Griffin, by the end of March 2016, Citigroup “had $2.1 trillion of notional credit derivatives and more total derivatives than any other U.S. lender.”
Earlier in that year, the bank purchased credit default swaps of Deutsche Bank to support its risk management strategy, and Citigroup’s leaders decided to apply this approach one more time. In its turn, Credit Suisse was focused on reducing the company’s leverage exposure through selling the CDS portfolio (Voegeli and Griffin). This approach was also followed by some other European financial services companies to address potential changes in the market while gaining immediate and regular payments (Augustin et al. 176; Voegeli and Griffin).
Leaders of Citigroup explain their decisions and activities concerning the advantages associated with applying CDS guarantees in case of credit situations (Lewitt). From this point, the number of derivatives owned by a financial institution can be viewed as proportional to the liquidity of this bank (Augustin et al. 177). However, the problem is in the fact that Citigroup’s strategy based on purchasing CDS is extremely threatening to be used as a technique to manage credit risks regularly.
As it is stated by financial experts, banks seem not to realize potential problems which are related to the active use of this approach to hedging credit risks (Lewitt; Voegeli and Griffin). This aspect should be discussed in detail with the focus on describing the nature of CDS and its role in the banking industry to answer the question about the effectiveness of this technique.
Credit Default Swaps to Manage Risks
Credit default swaps were first introduced as a measure to address risks by specialists of J. P. Morgan Inc. in 1994 (Augustin et al. 176). Today, this strategy is discussed as an easy method to predict difficulties associated with defaults. When receiving a certain fee, a seller of CDS agrees to protect a buyer of CDS in case of risky credit events and defaults which are discussed in the agreement (Augustin et al. 176; Voegeli and Griffin).
Currently, the CDS market is viewed as actively developing in the United States with a focus on the banking industry even though the reference to CDS is considered to be one of the causes of the financial crisis in 2008 (Voegeli and Griffin). However, despite the identified problems, the CDS market seems to be rather liquid in comparison to other debt or bond markets.
The reason for the popularity of credit default swaps is in guaranteeing insurance in cases when banks doubt regarding their partners, issuers, or creditors among other involved stakeholders (Augustin et al. 178). The shift of credit risk to another party seems to be an easy strategy to follow to avoid insolvency. As a result, any possible credit risks seem to be mitigated with the help of providing some payments stated in the contract (Augustin et al. 178).
Such type of credit protection provides a buyer of CDS with the certain security that is important to remain competitive in the financial sphere. If there are no risky situations, a buyer pays for security, and if there are credit situations, this buyer protects its assets without significant losses.
Role of Credit Default Swaps in the Banking Industry: Case Analysis
In 2016, it was possible to observe a controversial situation in the banking industry of the United States and Europe regarding the purchase and use of derivatives and CDS among them. The agreement between Citigroup and Credit Suisse can illustrate certain problems related to selling and purchasing CDS. From 2015 to 2016, many banks tried to get rid of their derivatives and other similar agreements because these instruments are rather risky to be effectively used in the industry without negative consequences (Lewitt; Voegeli and Griffin).
Still, Citigroup focused on its path which was previously taken before 2008, and in August 2016, the bank held extremely many derivatives with “a staggering total exposure of nearly $56 trillion” (Lewitt). It is important to note that the leaders of the bank selected this risk mitigation strategy as an effective one to address potential credit situations even though financial experts regard this approach as even more threatening than the absence of such protection (Lewitt; Voegeli and Griffin).
Analyzing this situation, it is necessary to state that Citigroup’s possibility to address potential defaults remains to be limited even with the focus on purchasing many derivatives. The situation is also risky for all sellers that participated in developing agreements with the bank in 2016. Still, according to Voegeli and Griffin, the discussed case indicates “how some of the biggest U.S. banks are looking to gain market share in trading from the restructurings of European rivals.”
Therefore, the potential consequences of this purchase for Citigroup can be both positive and negative. One more reason for buying more derivatives is associated with a direct realization of a credit risk management strategy because of the necessity to demonstrate that Citigroup is liquid (Lewitt). In this context, the purchase of CDS works like insurance that attracts more depositors.
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However, even though Citigroup seems to benefit in the future from buying derivatives in the context of positive trends in the financial market, the growth of the CDS market negatively influences the financial system. The strategy of buying credit default swaps creates insurance and some guarantees for certain banks under “perfect” conditions when the economic situation in a country and globally is stable.
However, a current extreme and uncontrolled growth of the CDS market creates significant risks for the banking industry (Voegeli and Griffin). According to Augustin et al., “banks’ use of CDS can create systematic risk because banks are both major buyers and sellers of CDS and are usually at the core of the CDS dealer network” (184). Thus, the risks associated with using CDS in the banking industry can be the following ones: increased rates of speculations and counterparty risks.
The problem is in the fact that if one party that participates in the agreement cannot provide fee or compensation payments, the other party loses resources (Voegeli and Griffin). Also, the financial crisis contributes to breaking contracts without providing payments and making financial institutions unable to prove their liquidity and overcome a critical situation.
The analysis of the case related to the use of credit default swaps in the banking industry indicates that this strategy to mitigate and address credit risks can have certain flaws even though it is used by financial institutions as the simplest way to guarantee and demonstrate the bank’s liquidity. When banks use this strategy regularly, it is possible to predict some negative consequences because of an institution’s increased dependence on the parties involved in the agreement.
Therefore, financial experts did not support Citigroup’s decision to buy CDS from Credit Suisse Group in 2016. Furthermore, the active growth of the CDS market creates many challenges for the financial market of the country because of the issue of parties’ interconnectedness. In a situation of a financial crisis, the protection cannot be provided to all banks that have derivatives.
Augustin, Patrick, et al. “Credit Default Swaps: Past, Present, and Future.” Annual Review of Financial Economics, vol. 8, no. 1, 2016, pp. 175-196.
Lewitt, Michael. “How to Profit When Citigroup’s $56 Trillion ‘Casino’ Catches Fire.” Money Morning. 2016. Web.
Voegeli, Jeffrey, and Donal Griffin. “Citigroup Said to Purchase CDS Portfolio from Credit Suisse.” Bloomberg. 2016. Web.