Credit Default Swaps

In chapter 3 of the notes they mention that credit default swaps can be used by lenders who have reached their internal credit limit with a particular client,but wish to maintain their relationship with that client.I do not get,how exactly can this be done.I do not see how the cds can reduce the limit.Can someone please enlighten me...forgive me for being dumb,lol

 

It doesn't reduce the limit, it just means that you can receive a payment to cover any excess over the limit, and hence your actual exposure is never more than the limit.

Or is your point more subtle than this?!

 

Thanks,I hadnt thought of it in that way,it makes much more sense now.

 

CDS is like an insurance for the buyer of CDS (in this case lender). Hence, gross credit risk (i.e. without CDS) to a particular client can exceed the internal credit limit defined by the lender however the net credit risk (i.e. after considering CDS), this may be well below the internal limit.

However, following points are worth noting in this regard:

(a) Lender will have additional credit risk of the CDS seller. This has become more significant with the last financial crises.

(b) CDS are not free and hence lender will have to pay a premium to the CDS seller. Thus, unless the return from incremental loan to the client is not greater than the premium paid for CDS, the arrangement won't make a financial sense.

Cheers!