Credit Default Swaps and the Stability of the Banking Sector

This paper considers credit default swaps (CDS) used for the transfer of credit risk within the banking sector. The banks' motive to conclude these CDS contracts is to improve the diversification of their credit risks. It is shown that these CDS reduce the stability of the banking sector in a recession. In a boom or in times characterized by a moderate economic up - or downturn, they can reduce this stability. The crucial points for these negative impacts to occur are firstly, that banks are induced to increase their investment into an illiquid, risky credit portfolio and secondly, that these CDS create a possible channel of contagion