Regulation, Credit Risk Transfer, And Bank Lending
The authors integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze lending behavior and risk sensitivity of a risk-neutral bank. The bank is exposed to credit risk and may use Credit Default Swaps (CDS) for hedging purposes. Regulation is found to induce the risk-neutral bank to behave in a more risk-sensitive way: under regulation there is a stronger decrease in the optimal volume of loans as the riskiness of loans increases. CDS trading is found to interact with the former effect when regulation accepts CDS as an instrument to mitigate credit risk.