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Credit derivatives, capital requirements and opaque OTC markets

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  • Nicolò, Antonio
  • Pelizzon, Loriana

Abstract

In this paper we study the optimal design of credit derivative contracts when banks have private information about their ability in the loan market and are subject to capital requirements. First, we prove that when banks are subject to a maximum loss capital requirement the optimal signaling contract is a binary credit default basket. Second, we show that if credit derivative markets are opaque then banks cannot commit to terminal-date risk exposure, and therefore the optimal signaling contract is more costly. The above results allow us to discuss the potential implications of different capital adequacy rules for the credit derivative markets.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Intermediation.

Volume (Year): 17 (2008)
Issue (Month): 4 (October)
Pages: 444-463

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Handle: RePEc:eee:jfinin:v:17:y:2008:i:4:p:444-463

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Web page: http://www.elsevier.com/locate/inca/622875

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Keywords: Credit derivatives Signaling contracts Capital requirements;

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References

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  1. Alan Morrison, 2000. "Credit Derivatives, Disintermediation and Investment Decisions," OFRC Working Papers Series 2001fe01, Oxford Financial Research Centre.
  2. Allen, Franklin & Carletti, Elena, 2005. "Credit risk transfer and contagion," CFS Working Paper Series 2005/25, Center for Financial Studies (CFS).
  3. Gregory R. Duffee and Chunsheng Zhou., 1999. "Credit Derivatives in Banking: Useful Tools for Managing Risk?," Research Program in Finance Working Papers RPF-289, University of California at Berkeley.
  4. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 651-66, November.
  5. Adam B. Ashcraft & João A. C. Santos, 2007. "Has the credit derivatives swap market lowered the cost of corporate debt?," Staff Reports 290, Federal Reserve Bank of New York.
  6. Alan D. Morrison, 2005. "Credit Derivatives, Disintermediation, and Investment Decisions," The Journal of Business, University of Chicago Press, vol. 78(2), pages 621-648, March.
  7. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 1-35.
  8. Gorton, Gary B. & Pennacchi, George G., 1995. "Banks and loan sales Marketing nonmarketable assets," Journal of Monetary Economics, Elsevier, vol. 35(3), pages 389-411, June.
  9. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  10. Sandeep Dahiya & Manju Puri & Anthony Saunders, 2003. "Bank Borrowers and Loan Sales: New Evidence on the Uniqueness of Bank Loans," The Journal of Business, University of Chicago Press, vol. 76(4), pages 563-582, October.
  11. Froot, Kenneth A. & Stein, Jeremy C., 1998. "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, Elsevier, vol. 47(1), pages 55-82, January.
  12. Minton, Bernadette A. & Stulz, Rene M. & Williamson, Rohan, 2005. "How Much Do Banks Use Credit Derivatives to Reduce Risk?," Working Paper Series 2005-17, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  13. Antonio Nicolo' & Loriana Pelizzon, 2005. "Credit Derivatives: Capital Requirements and Strategic Contracting," "Marco Fanno" Working Papers 0006, Dipartimento di Scienze Economiche "Marco Fanno".
  14. Guillaume Plantin & Christine A Parlour, . "Credit Risk Transfer," GSIA Working Papers 2005-E45, Carnegie Mellon University, Tepper School of Business.
  15. In-Koo Cho & David M. Kreps, 1997. "Signaling Games and Stable Equilibria," Levine's Working Paper Archive 896, David K. Levine.
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Citations

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Cited by:
  1. Chiesa, Gabriella, 2008. "Optimal credit risk transfer, monitored finance, and banks," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 464-477, October.
  2. Bosma, Jakob & Koetter, Michael & Wedow, Michael, 2012. "Credit risk connectivity in the financial industry and stabilization effects of government bailouts," Discussion Papers 16/2012, Deutsche Bundesbank, Research Centre.
  3. Parlour, Christine A. & Winton, Andrew, 2013. "Laying off credit risk: Loan sales versus credit default swaps," Journal of Financial Economics, Elsevier, vol. 107(1), pages 25-45.
  4. Arnold, Marc, 2013. "The Impact of the Regulation of Centrally Cleared Credit Risk Transfer and Capital Requirements on Banks’ Lending Discipline," Working Papers on Finance 1321, University of St. Gallen, School of Finance.
  5. Ahn, Jung-Hyun & Breton, Régis, 2014. "Securitization, competition and monitoring," Journal of Banking & Finance, Elsevier, vol. 40(C), pages 195-210.
  6. Arnold, Marc, . "Banks’ Loan Screening Incentives with Credit Risk Transfer: An Alternative to Risk Retention," Working Papers on Finance 1402, University of St. Gallen, School of Finance.
  7. Liu, Luke, 2011. "Securitization and moral hazard: Does security price matter?," MPRA Paper 35004, University Library of Munich, Germany.
  8. Li, Zhe & Sun, Jianfei, 2011. "Bank competition, securitization and risky investment," MPRA Paper 34173, University Library of Munich, Germany.
  9. Bülbül, Dilek & Lambert, Claudia, 2012. "Credit portfolio modelling and its effect on capital requirements," Discussion Papers 11/2012, Deutsche Bundesbank, Research Centre.
  10. Cerasi, Vittoria & Rochet, Jean-Charles, 2014. "Rethinking the regulatory treatment of securitization," Journal of Financial Stability, Elsevier, vol. 10(C), pages 20-31.
  11. Laux, Christian, 2008. "Corporate insurance design with multiple risks and moral hazard," CFS Working Paper Series 2008/54, Center for Financial Studies (CFS).

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