Regulation, Credit Risk Transfer with CDS, and Bank Lending

Abstract

We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank . CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price . Regulation is found to induce the risk-neutral bank to behav e in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases . CDS trading is found to interact with the former ef fect when regulation accepts CDS as an instrument to mitigate credit risk . Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased . Howev er, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased . This promotes the intention of the Basel II (and III) r egulations to “strengthen the soundness and stability of banks” . * Paper presented at the 2012 conferences of the European Financial Management Association (EFMA) in Barcelona and the Verein fur Socialpolitik in Gottingen, at the 2011 conference of the German Economic Association of Business Administration (GEABA) in Zurich, at the Financial Risks International Forum 2012 in Paris, at the 2011 workshop of the Research Task Force of the Basel Committee on Banking Supervision in Istanbul, and at the Bundesbank Research Seminar in Frankfurt . We w ould like to thank conference, workshop and seminar participants and in particular Ulrich Krueger, Peter Raupach, Thomas Gehrig, Bent Vale and Nikolaos Papanikolaou for valuable comments and suggestions . The views expr essed in this paper represent the authors’ personal opinions and do not neces