Has Financial Innovation Made the World Riskier? CDS, Regulatory Arbitrage and Systemic Risk

Abstract

The paper analyzes the use of credit default swaps (CDS) for regulatory capital relief and its consequences for systemic risk. Equity capital acts as a buffer against losses, and reduces incentives for excessive risk taking. Basel capital regulation states that banks can lower capital requirements using CDS. When the cost of capital is too steep, CDS allows banks to invest in good projects, which would have been by-passed otherwise. However, CDS can also be used for regulatory arbitrage to lower capital requirements resulting in excessive risk taking. Furthermore, the bank and the CDS seller (insurer) prefer high correlation in their returns and jointly shift the risk to the regulator. CDS can be traded at a price higher than its fair value reflecting the value of capital relief. I also analyze how the correlation between the insurer and the bank can be determined endogenously through the volume of CDS the insurer sells, and how CDS can help banks expand balance sheets and fuel asset price bubbles.