Credit Derivatives, Capital Requirements and Opaque OTC Markets

How does bank capital regulation affect the design of credit derivative contracts? How does the opacity of the OTC credit derivative markets affect these contracts? In this paper we address these issues and characterize the optimal security design in several settings. We show that both the level of the banks' cost of capital and the opacity of the credit derivative markets do affect the form of the optimal separating contract and the level of the banks' profits. Moreover, our results suggest that the optimal contracts are largely dependent on bank regulation. More specifically, the introduction of Basel II may prevent the use of the equity tranche in CDO contracts as a signaling device. In addition, the presence of private credit derivative contracts would make the use of signaling contracts able to solve the adverse selection problem quite expensive.