Thilo Pausch, Peter Welzel
Regulation, Credit Risk Transfer, and Bank Lending
Abstract:
We integrate Basel II (and III) regulations into the industrial
organization approach to banking and analyze lending behavior and risk
sensitivity of a risk-neutral bank. The bank is exposed to credit risk
and may use credit default swaps (CDS) for hedging purposes. Regulation
is found to induce the risk-neutral bank to behave 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 effect 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. This interaction promotes the intention of the Basel II (and
III) regulations to “strengthen the soundness and stability
of banks”, since capital adequacy regulation without
accounting for the risk-mitigating effect of CDS trading would
stimulate a risk-neutral bank to take more extreme positions in the CDS
market.
JEL: G21, G28
Paper:
Paper available as pdf-file.
Beitrag Nr. 316, Volkswirtschaftliche Diskussionsreihe, Institut
für
Volkswirtschaftslehre der Universität Augsburg
Contact:
Thilo Pausch, Deutsche Bundesbank Frankfurt
email: thilo.pausch@bundesbank.de
Peter
Welzel, University of Augsburg, Department of Economics,
D-86135
Augsburg,
Germany, phone +49-821-598-4185, fax +49-821-598-4230
email: peter.welzel@wiwi.uni-augsburg.de
Bo., 21.03.2011