Another day, another examination of the systemic risk posed by the rise of the CDS market. This time, it's John Plender of the FT doing the warning, under the headline "The credit business is more perilous than ever".

Not all central bankers worry about this. Some see financial innovation as a boon, arguing that transferring risk from banks to non-bank investors makes the system more robust since the risk is diversified and better managed. Up to a point they are right.
Yet there is an immutable law of insurance that says that, while hedging can reduce the risk to the individual party taking out the insurance, it increases the risk for the system as a whole because of moral hazard. That is, the mere existence of insurance means people become less risk averse. And that, complete with the marked decline in risk premiums and in lending standards, is the story of credit markets this decade.

Plender is right that banks who sell or hedge most of their credit risk are likely to be less zealous about underwriting standards. But the people buying the risk aren't stupid, and – unlike banks – they actually want it.

Plender worries what happens when the music stops, and in particular worries that no bailout will be able to be orchestrated:

It is easy enough to share data. Fiscal burden-sharing is another matter. If, for example, an insolvent bank that poses an EU-wide systemic threat has more deposits outside its home country than in, few local politicians will want to spend taxpayers' money on voteless foreigners, including global banking giants in London's financial adventure playground. Lenders of last resort will in future be more elusive. And banking crises will be messy.

But the whole point of his article is that banks are actually reasonably well insulated from a credit-market meltdown – certainly much more so than they have been in the past. The first victims of such an event would be the hedge funds and other investors who have been writing CDS contracts. Those entities have a huge amount of equity – hundreds of billions, if not trillions, of dollars – which would have to be wiped out before a systemic crisis overflowed the hedge funds and hit the banking sector in a serious way.

Banks are good loan originators, but they're not optimal loan owners. Depositors want their money to be 100% safe. Investors in hedge funds, on the other hand, are much better loan owners, since they are perfectly aware that their investments can go down instead of up. So it's really quite a good idea that banks do the origination, while hedge funds end up with the risk.

Has the Explosive Growth of Credit Derivatives Increased the Risk of a Systemic Crisis?