Credit default swaps, regulatory arbitrage and banking regulation

Abstract

This paper analyzes theoretically the impact of credit default swaps (CDS) on the regulatory capital required in a banking system. We develop a simple capital requirement model with and without CDS, which shows that CDS reduces banking system capital ratio. The model also highlights the regulator’s ability to use prudential ratios at their disposal to limit regulatory arbitrage. An enhancing of this model via a reduced-form default model, inspired by Duffie and Singleton (1999), shows the possibility for banks facing the regulator’s desire to reduce regulatory arbitrage, to affect the level of regulatory capital savings. This becomes possible if the CDS market gives them the opportunity to influence some parameters related to the CDS market value: the default intensity, the partial recovery rate, the spread, the risk-free rate. Therefore, in addition to its intervention on prudential ratios, the regulator should limit regulatory arbitrage effectively by intervening also in the CDS market to counter the strategic use of CDS by banks.

Key words: bank, prudential regulation, regulatory arbitrage, credit default swaps.

JEL Classification: G19, G28, G33