N°25-107: The Impact of Credit Default Swaps on Systemic Risk: Macroprudential Solvency and Liquidity Stress Testing

We analyze solvency and liquidity implications of Credit Default Swaps (CDS) in banking networks. We emphasize that one can neither isolate them, nor just analyze them in parallel, but needs to consider their complex interplay. By calibrating our model to the largest banks in the Euro area, we are able to run a large-scale stress test and isolate the effect of different network configurations, as well as different overall coverages of CDS, on systemic risk. An increase in CDS notional always leads to an increase in liquidity risk. The impact on solvency risk is conditional on the topology of the network. We provide a robust network configuration for which an increase in CDS notional leads to a decrease in solvency risk.