Credit Risk Sharing and Credit Market Regulation

Abstract

I show how aggregate risk influences credit default swap (CDS) markets and CDS regulation in a novel, analytically tractable general equilibrium model. For low aggregate risk levels, the unique competitive equilibrium of the economy with unregulated CDS markets is efficient with bondholders being fully insured and all capital invested in risky productive firms. Hence, a general efficient allocation on the Pareto frontier, which could differ from the competitive equilibrium allocation due to redistributive concerns of a social panner, can be implemented via transfers alone. For intermediate aggregate risk levels, a general efficient allocation requires bondholders to bear aggregate risk and nonzero investment in the safe asset. In this case, in addition to transfers, a margin requirement on CDS sellers that forces them to invest in the safe asset is also necessary to implement the general efficient allocation. If aggregate risk is sufficiently high, there is no competitive equilibrium of the economy with unregulated CDS markets. A margin requirement on CDS sellers restores equilibrium and efficiency. However, it could be maximally stringent in which case constraints on CDS purchases by buyers are also necessary to ensure that aggregate risk is efficiently shared among agents, and that the relative investments in productive firms and the safe asset match the efficient allocation. Taken together, my study rationalizes the breakdown of poorly regulated CDS markets during the financial crisis and provides a normative analysis of the optimal design of CDS regulation in the presence of aggregate shocks.

Keywords: Credit Risk Sharing, Credit Default Swaps, Regulation

JEL Classification: G22, G28, D52