How Banks Adapt to Capital Requirements Using Countercyclical Buffers

Summary Focus This paper examines how banks adjust to higher capital requirements, specifically through the use of credit default swaps (CDS). While banks traditionally respond to tighter capital regulations by raising equity or reducing lending, this study highlights an alternative strategy: hedging credit risk using CDS. Our analysis focuses on the countercyclical capital buffer (CCyB), a macroprudential tool that varies across countries and over time, to explore how banks manage their capital constraints in response to regulatory changes. Contribution Our study contributes to the understanding of how modern financial markets interact with regulatory policies. By linking granular data on syndicated loans and transaction-level data on the CDS market, we provide novel evidence on the role of credit derivatives as a tool for regulatory capital management. We move beyond the traditional narrative of banks cutting lending in response to higher capital requirements and shed light on how CDS markets enable banks to meet regulatory demands while maintaining credit supply. Findings We find that banks significantly increase their use of CDS to hedge loans in countries where CCyB rates rise. A 1 percentage point increase in the CCyB reduces the uninsured share of a loan by approximately 53 percentage points, with the strongest response from banks most exposed to the affected country. This hedging behaviour allows banks to reduce risk-weighted assets without necessarily cutting lending, potentially mitigating the impact of tighter capital requirements on credit availability. However, the findings also raise questions about the effectiveness of capital buffers, as banks may use derivatives to circumvent the intended constraints on risk-taking by optimising eligible risk transfers. Abstract When capital requirements rise, banks can raise equity or reduce risk-weighted assets, typically by cutting lending. We show they also use credit default swaps (CDS). Linking EU trade-repository CDS data to syndicated loans for November 2017 to April 2024, we document that banks significantly increase CDS hedging on loans to firms in countries that raise their countercyclical capital buffer (CCyB). Our identification exploits within-bank comparisons of hedging for similar borrowers across countries with different CCyB rates. A 1 percentage point increase in the CCyB reduces the uninsured share of a loan by about 53 percentage points, with the strongest effects for banks most exposed to the buffer-raising country. Eligible credit risk transfer via CDS thus emerges as a first-order channel through which banks accommodate tighter capital requirements, potentially attenuating macroprudential policy transmission. JEL Classification: E51, G21, G28, G32