Credit derivatives: Banks' behaviour, financial stability and banking regulation

Abstract

This paper studies the emergence and development of credit derivatives, and how they have significantly changed the area of credit risk management. In studying the behavioural effects of credit derivatives on banks' behaviour, the theoretical analysis incorporates the modelling of optimal bank capital reserves with the use of credit derivatives by employing an inventory management framework. It is shown that credit derivatives can lead banks to reduce their capital buffer stock, which can have multiple effects on banks' behaviour. By considering these effects in parallel with the existing literature, this paper investigates the implications of credit derivatives with respect to financial stability and banking regulation.