Credit derivatives in banking; analysis of their effects for the share holder value, risk management organization which help for their efficient use and the financial reporting

Although the exposure to the credit risk is a condition that is relevant for the institutions possessing the ?bank? title, the inefficient credit risk management would adversely affect the whole economy as the banks may incur losses under some cases such as the payment of neither the principal nor the interests or the default of a contractual obligation over a financial asset or loss of reputation or downgrade of the credit rating. These cases that define the credit risk may trigger a process that would both increase the banks? capital requirements in proportion to the incurred loss and limit lending activities which would either slow down or hinder the transfer of the necessary funds to the parties in need. This process points out a financial crisis which is defined by Mishkin as the ?disruption in the financial markets in which asymmetric information and hence adverse selection and moral hazard problems become much worse, so that financial markets are unable to channel funds efficiently to those with the most productive investment opportunities?. Accordingly, it is of high importance that prior to lending or acquiring a financial asset, banks should effectively analyse the credit risk and put into practice the mitigation ways against it.Credit risk mitigation is given special attention in Basel-II Capital Accord. One of the most popular ways of credit risk mitigation is to use credit derivative transactions. These transactions consist of Credit Default Swaps (CDS), Total Return Swaps (TRS) and Credit Linked Notes (CLN). In this study, three topics about the credit risk mitigation via mentioned transactions are elaborated. First of all, it is debated whether it would be appropriate to generalize the credit derivatives transactions would not only decrease the capital adequacy requirement but also increase the value of the bank. It is concluded that the individual use of credit derivatives would not increase the value of the bank, whereas additional lending or acquiring a financial asset bearing credit risk by an amount equal to the capital requirement reduced by using credit derivatives would increase both bank?s and its credit portfolio value and also positively affect the risk adjusted performance indicators. This result is consistent with the results of the previous studies which postulate that credit derivatives cause the banks to incur more risks. However, the increase in the value of the bank would materialize if the equation, that I have derived using Arbitrage Pricing Model, is satisfied. This model takes into account the cost of the credit derivative, the yield of the lending that would be extended by an amount equal to the reduced capital requirement and target yield of the capital. Second of all, it is debated whether the decision regarding the credit risk mitigation via these transactions should be taken before or after the decision to lend or to acquire a financial asset. By showing a mathematical equation it is concluded that, with the implementation of Basel II accord, the mentioned decision should be taken in advance as these transactions would facilitate the determination of the interest rates that would be demanded from the credit customer(s) in a way to create a competitive advantage. A model has been developed for the risk management organization that would serve this aim. Third of all, how to conduct the financial reporting of the credit derivatives is debated. The booking process and the explanations which will be given in the financial reports regarding the mentioned transactions are explained with the examples as to the IAS 32, 39 and IFRS 7 and 9. In addition to this, it is deliberated that IAS 39 should be reviewed within the context of Credit Default Swap contracts based on the credit events such as the default of the counterparty in a credit risk bearing transaction, the failure to pay the minimum amount for the principal and/or interest in the predetermined period, the early amortization of the credit obligation, declaration of moratorium or denial of the debt or debt restructuring.