CDS pricing under Basel III: capital relief and default protection

TL;DR

This paper develops a CDS pricing model incorporating capital relief under Basel III, showing that a significant portion of observed spreads may be due to this capital relief, especially differing between IMM and non-IMM banks.

Contribution

It introduces a three-legged CDS pricing model that accounts for capital relief, providing bounds on hazard rates in incomplete markets and quantifying the impact on spreads.

Findings

20% to over 50% of CDS spreads may be due to capital relief

Market incompleteness affects CDS pricing bounds

Differential pricing expected between IMM and non-IMM banks

Abstract

Basel III introduces new capital charges for CVA. These charges, and the Basel 2.5 default capital charge can be mitigated by CDS. Therefore, to price in the capital relief that CDS contracts provide, we introduce a CDS pricing model with three legs: premium; default protection; and capital relief. If markets are complete, with no CDS bond basis, then CDSs can be replicated by taking short positions in risky floating bonds issued by the reference entity and a riskless bank account. If these conditions do not hold, then it is theoretically possible that the capital relief that CDSs provide may be priced in. Thus our model provides bounds on the CDS-implied hazard rates when markets are incomplete. Under simple assumptions we show that 20% to over 50% of observed CDS spread could be due to priced in capital relief. Given that this is different for IMM and non-IMM banks will we see differential pricing?