Credit Derivatives Under The New Basel Capital Accord And Banks' Risk Management Study

The late 1990's witnessed the advent and rise of two innovations that have since been driving the evolution of the international banking industry. One is called the Basel I, an international accord for banking regulation; the other credit derivatives, a kind of financial instrument that allows transfer of credit risk to those who are willing and best able to bear it. The former has been improved and refined into Basel II with a consolidated position as the international norm for banking regulation, whereas the latter has found widespread use in modern banking portfolio management.This paper aims to explore how credit derivatives can be used to mitigate credit risk in a bank, how they can be incorporated into its overall risk management function and what implications their utilization has for its core competitiveness in light of Basel II. This paper first presents an anatomy of credit derivatives, especially credit default swap and total return swap. It is then emphasized that implementing credit derivatives should be pursued in such a way as to both meet the realistic needs of a bank and beef up its risk management capabilities consistent with the rationales and principles of Basel II. Finally, with reference to Holmstrom and Tirole (2000), a simple three-period model featuring moral hazard is built to look into the decision-making of a banker with regard to his use of hedge against credit risk in compliance with Basel II in the context of a banker-regulator game. We thus justify the need for a minimum capital requirement and under certain assumptions come up with analytical solutions for the capital adequacy ratio and optimal hedging ratio.