CDS Pricing under Basel III: Capital relief and default protection

by Chris Kenyon of Lloyds Banking Group, and
Andrew Green of Lloyds Banking Group

November 22, 2012

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?

JEL Classification: G13, G18.

AMS Classification: 91G40, 62P05, 90A09, 91B28.

Keywords: CDS, Basel III, capital, capital relief, incomplete markets, IMM, CEM, regulations, hazard rates, CVA.

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