The news is gradually filtering down from big banks to small: credit derivatives can be a wonder drug. Widely regarded as a form of Viagra for commercial banks, credit derivatives enable banks to leverage their balance sheets by buying new assets or selling the risk of existing loans. By playing these growing credit markets, banks can diversify their lending risk, hedge or add to existing exposures. The idea is a revelation for banks trapped in a dull and unprofitable cycle of lending to familiar customers at ever-shrinking margins.
German Landesbanken, for instance, enjoyed discovering asset swaps and credit derivatives in the past 18 months. They diversified loan portfolios which concentrated on regional and public-sector borrowers into the thrilling world of emerging-market debt. Earlier this year they withdrew, wounded by heavy losses in Asia and have become more cautious. According to Christian Porath, German credit derivatives specialist at Credit Suisse Financial Products (CSFP), Landesbanken are now taking on risks no lower than double A (except for German corporates). That is about as exciting and lucrative as lending to the city of Düsseldorf.
Buying in new risks through credit derivatives was just the start.