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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
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Handle: RePEc:pad:wpaper:0006

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  1. Franke, Günter & Krahnen, Jan Pieter, 2005. "Default risk sharing between banks and markets: The contribution of collateralized debt obligations," CFS Working Paper Series 2005/06, Center for Financial Studies (CFS).
  2. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 96-28, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Gorton, Gary B. & Pennacchi, George G., 1995. "Banks and loan sales Marketing nonmarketable assets," Journal of Monetary Economics, Elsevier, Elsevier, vol. 35(3), pages 389-411, June.
  4. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, Econometric Society, vol. 67(1), pages 65-100, January.
  5. Duffee, Gregory R. & Zhou, Chunseng, 1999. "Credit Derivatives in Banking: Useful Tools for Managing Risk?," Research Program in Finance, Working Paper Series, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley qt7g67n911, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
  6. Repullo, Rafael & Suarez, Javier, 2003. "Loan Pricing Under Basel Capital Requirements," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3917, C.E.P.R. Discussion Papers.
  7. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, Elsevier, vol. 33(3), pages 341-368, June.
  8. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, American Finance Association, vol. 32(2), pages 371-87, May.
  9. In-Koo Cho & David M. Kreps, 1997. "Signaling Games and Stable Equilibria," Levine's Working Paper Archive 896, David K. Levine.
  10. Bank for International Settlements, 2003. "Credit risk transfer," CGFS Papers, Bank for International Settlements, number 20.
  11. Elizalde, Abel & Repullo, Rafael, 2004. "Economic and Regulatory Capital: What is the Difference?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4770, C.E.P.R. Discussion Papers.
  12. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, American Economic Association, vol. 71(3), pages 393-410, June.
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Cited by:
  1. Kiff, John & Kisser, Michael, 2014. "A shot at regulating securitization," Journal of Financial Stability, Elsevier, Elsevier, vol. 10(C), pages 32-49.
  2. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(1), pages 89-111, January.
  3. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, Elsevier, vol. 31(1), pages 121-139, January.
  4. 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".
  5. Wagner, Wolf & Marsh, Ian W., 2006. "Credit risk transfer and financial sector stability," Journal of Financial Stability, Elsevier, Elsevier, vol. 2(2), pages 173-193, June.

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