Abstract

 Kyoo H. Kim
Department of Economics
Bowling Green State University
Bowling Green, Ohio 43403
The recent enormous growth in bank loan sales as collateral in Collateralized Debt Obligations is considered one of the sources of the current financial market meltdown and global economic crisis.  Empirical findings show that the difference between the historical defaults and spreads in the secondary loan market has increased sharply for the higher credit rated securities. As an example, in the credit default swap market, the bank spread jumped in the US from the 21 basis points before August 2007 to the 271 basis points right after the failure of the Lehman Brothers in September 2008. This development explains an ongoing significant financial market stress and banking failures and compels the regulatory authorities to reconsider the current banking regulation. The bank failures impose a social cost of excessive lax regulation, justifying a more stringent bank regulation.  The paper is to focus on a microeconomic aspect of banking regulation, to be specific, to investigate both the risk-incentive mechanism in banking contracts and the current global system of bank capital regulation to draw its policy implications in light of the current financial disintermediation and banking market stress.
            There is a disappointment of the performance of the current global regulation. Basel process has been under-compromised by the inadequacies of the produced agreement of bank capital.  Under Basel II, bank capital weights are supposed to increase with respect to the riskiness of loans. With the advent of the secondary loan market in 1990s, the bank’s opportunity costs of bearing loans have decreased. Banks shifted their investment portfolios away from corporate loans. This observation is obviously applied to the emergence of the credit default swap market, in which banks buy insurance contracts against credit defaults. Banks saw no difference between loan sales and credit default swaps, both of which allow the banks to release capital subject to regulation. Banks are able to transfer credit risks and do way from the Basel II capital regulation.
             I present a banking model with imperfect competition.  Banks are allowed in asset allocation decision to invest in credit risk transfers (CRTs), such as credit default swaps.  The model shows that CRT improves the access to finance for risky borrowers by increasing banks’ risk-bearing scope and thereby relaxing capital regulation, but reducing incentives to monitor the borrowers and creating inefficiencies.  The paper has two key features.  First it is a model of monopolistic competition adapted from the Salop’s spatial competition.  Second, a welfare maximizing capital regulation is discussed.  I would find the welfare maximizing capital regulation and compare it to the current Basel II type of bank capital regulation that rely on credit ratings and bank’s own choice of risk weights for capital requirements. The paper is expected to produce a result that those current risk–based capital requirements for banks should be adjusted to balance financial stability and welfare.