Credit Derivatives: Capital Requirements and Strategic Contracting

In this paper we show how credit derivatives contracts may be designed to hedge risky credits when banks have to comply with capital requirements and there exists asymmetric information between protection buyers and sellers. In particular we consider the case when banks may of different types according to their ability in screening their borrowers. We show that first-to-default basket swaps in which the contract terminates when any of the underlying assets of the basket defaults may credibly signal the high quality of the protection buyer. We also provide a simple model in which a moral hazard problem arises and we show that first-to-default contracts provide better incentive than plain vanilla contracts in order for the buyers to exert an efficient level of monitoring. Finally we discuss how the new Basel Agreement impacts on the equilibrium of the credit derivative market and we propose some possible regulatory reforms. JEL Classification: G21, D82 ∗Preliminary version. We gratefully acknowledge conversations with Viral Acharya, Andrea Beltratti, Gabriella Chiesa, Ottorino Chillemi, Francesco Corielli, Marcello Esposito, Anke Gerber, Fabio Manenti, Giovanna Nicodano, Bruno Parigi, Stephen Schaefer, Walter Torous, Guglielmo Weber, seminar audiences at University of Padua and University of Bologna and participants at Centro Baffi Workshop, Milan. A particular thank to Douglas Gale and Ilya Strebulaev for many useful comments on an earlier version of this paper. Isabella Massa provided excellent research assistantship. All errors are our own. Financial support by Paolo Baffi Centre and MURST are gratefully aknowledged. †Corresponding author. Postal: Dipartimento di Scienze Economiche, Via del Santo 33, Padova, Italy, Phone +39 049 8274054, Fax +390498274211, [email protected].