Monday, August 19, 2013

Credit Risk Transfer: To Sell or to Insure - Queen's Economics

Credit Risk Transfer: To Sell or to Insure - Queen's Economics ...Credit Risk Transfer: To Sell or to Insure James R. Thompson⁄ Department of Economics, Queen’s University First Version: December 2005 This Version: June 2007 Abstract This paper analyzes credit risk transfer in banking. Speciflcally, we model loan sales and loan insurance (e.g. credit default swaps) as the two instruments of risk transfer. Recent empirical evidence suggests that the adverse selection problem is as relevant in loan insurance as it is in loan sales. Contrary to previous literature, this paper allows for informational asymmetries in both markets. We show how credit risk transfer can achieve optimal investment and minimize the social costs associated with excess risk taking by a bank. Furthermore, we flnd that no separation of loan types can occur

in equilibrium. Our results show that a well capitalized bank will tend to use loan insurance regardless of loan quality in the presence of moral hazard and relationship banking costs of loan sales. Finally, we show that a poorly capitalized bank may be forced into the loan sales market, even in the presence of possibly signiflcant relationship and moral hazard costs that can depress the selling price. Keywords: credit risk transfer, banking, loan sales, loan insurance JEL Classiflcation Numbers: G21, G22, D82. ⁄Address: Dunning Hall, 94 University Ave., Kingston, ON K7L 3N6, Canada, Telephone: 1-613-533-6000 ext. 75955, E-mail: thompsonj@econ.queensu.ca. The author is grateful to Frank Milne, Jano Zabojnik, Thor Koeppl, and Sumon Majumdar as well as Kimmo Berg, Allen Head, Jean-Charles Rochet, seminar participants at Queen’s University and the 2006 CEA Annual Meetings for helpful comments and discussions. 1 Introduction The growth in credit risk transfer (CRT), and speciflcally, credit derivatives since the mid- 90s has been large. Instruments such as bank loans, once virtually illiquid, can now have their risk stripped down and traded away. Indeed, how we view the role of banking institutions is fundamentally changing. The growth in credit derivatives is illustrated in flgure 1, where we see that the notional out- standing value has surpassed $12 trillion. Figure 2 is based on a survey of some of the largest flnancial institutions in the world. The average weekly trading volume for various derivative instru- ments is reported. We see that credit derivatives have overtaken plain vanilla" equity derivatives in options activity for banks. [Figure 1 about here] [Figure 2 about here] Dufiee and Zhou (2001) gave us our flrst insight into the theoretical usage of both credit deriva- tives and loan sales.1 The authors show how credit derivatives can help alleviate the lemons" problem that plagues the loan sales market and that it is possible that the introduction of credit derivatives could shut down the loan sales market. This paper builds on Dufiee and Zhou (2001), but departs from it in two important ways. First, an assumption that is pivotal to their lemons result is that loan insurance is used when no informational asymmetries exist between the bank and the potential insurer. Recent empirical evidence by Acharya et al. (2005) suggests that banks are acting on their privileged information in credit default swaps (loan insurance) markets. In their analysis, they flnd signiflcant information is revealed within these...

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