Abstract

http://ssrn.com/abstract=2176493
 
 

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Has Financial Innovation Made the World Riskier? CDS, Regulatory Arbitrage and Systemic Risk


Tanju Yorulmazer


Federal Reserve Bank of New York

April 23, 2013


Abstract:     
The paper analyzes the use of credit default swaps (CDS) for regulatory capital relief and its consequences for systemic risk. Equity capital acts as a buffer against losses, and reduces incentives for excessive risk taking. Basel capital regulation states that banks can lower capital requirements using CDS. When the cost of capital is too steep, CDS allows banks to invest in good projects, which would have been by-passed otherwise. However, CDS can also be used for regulatory arbitrage to lower capital requirements resulting in excessive risk taking. Furthermore, the bank and the CDS seller (insurer) prefer high correlation in their returns and jointly shift the risk to the regulator. CDS can be traded at a price higher than its fair value reflecting the value of capital relief. I also analyze how the correlation between the insurer and the bank can be determined endogenously through the volume of CDS the insurer sells, and how CDS can help banks expand balance sheets and fuel asset price bubbles.

Number of Pages in PDF File: 39

Keywords: capital requirements, leverage, asset bubbles, deposit insurance

JEL Classification: G01, G18, G21, G22, G28

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Date posted: November 15, 2012 ; Last revised: April 26, 2013

Suggested Citation

Yorulmazer, Tanju, Has Financial Innovation Made the World Riskier? CDS, Regulatory Arbitrage and Systemic Risk (April 23, 2013). Available at SSRN: http://ssrn.com/abstract=2176493 or http://dx.doi.org/10.2139/ssrn.2176493

Contact Information

Tanju Yorulmazer (Contact Author)
Federal Reserve Bank of New York ( email )
33 Liberty Street
New York, NY 10045
United States
HOME PAGE: http://www.ny.frb.org/research/economists/yorulmazer/index.html
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