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Credit Derivatives: Capital Requirements and Strategic Contracting

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  • Antonio Nicolo'

    ()
    (University of Padua)

  • Loriana Pelizzon

    ()
    (University of Venice)

Abstract

In this paper we investigate the problem of a bank, which, due to the presence of capital requirements, needs to issue credit derivatives. Because of asymmetric information in the loan and credit risk transfer markets, banks face an adverse selection problem, sharpened by the fact that credit derivative contracts are not publicly observable. We show that high-quality banks can use CDO contracts to signal their own type, even when credit derivatives are private contracts. Also a menu of contracts with a first-to-default basket and a credit default swap conditioned to the default of the first asset, can be used as a signalling device. Moreover, this last menu of contracts generates larger profits for high-quality banks than the CDO contract if the cost of capital and the loan interest rates are su¢ ciently high.

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Bibliographic Info

Paper provided by Dipartimento di Scienze Economiche "Marco Fanno" in its series "Marco Fanno" Working Papers with number 0006.

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Length: 33 pages
Date of creation: Oct 2005
Date of revision:
Handle: RePEc:pad:wpaper:0006

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  1. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters, in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc.
  2. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," NBER Working Papers 5403, National Bureau of Economic Research, Inc.
  3. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 25-54, August.
  4. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  5. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  6. Bank for International Settlements, 2003. "Credit risk transfer," CGFS Papers, Bank for International Settlements, number 20, July.
  7. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, vol. 33(3), pages 341-368, June.
  8. Repullo, Rafael & Suarez, Javier, 2003. "Loan Pricing Under Basel Capital Requirements," CEPR Discussion Papers 3917, C.E.P.R. Discussion Papers.
  9. Gary Gorton & George Pennacchi, 1990. "Banks and Loan Sales: Marketing Non-Marketable Assets," NBER Working Papers 3551, National Bureau of Economic Research, Inc.
  10. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, vol. 32(2), pages 371-87, May.
  11. Abel Elizalde & Rafael Repullo, 2004. "Economic And Regulatory Capital. What Is The Difference?," Working Papers wp2004_0422, CEMFI.
  12. Cho, In-Koo & Kreps, David M, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 179-221, May.
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Cited by:
  1. Allen, Franklin & Carletti, Elena, 2005. "Credit risk transfer and contagion," CFS Working Paper Series 2005/25, Center for Financial Studies (CFS).
  2. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
  3. Kiff, John & Kisser, Michael, 2011. "A Shot at Regulating Securitization," Discussion Papers 2011/7, Department of Business and Management Science, Norwegian School of Economics.
  4. Wagner, Wolf & Marsh, Ian W., 2006. "Credit risk transfer and financial sector stability," Journal of Financial Stability, Elsevier, vol. 2(2), pages 173-193, June.
  5. Antonio Nicolo’ & Loriana Pelizzon, 2006. "Credit Derivatives, Capital Requirements and Opaque OTC Markets," Working Papers 2006_58, Department of Economics, University of Venice "Ca' Foscari".

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