Laying off Credit Risk: Loan Sales versus Credit

Laying o Credit Risk: Loan Sales versus Credit Default Swaps Christine A. Parloury Andrew Winton z August 29, 2008 Abstract After making a loan, a bank nds out if the loan needs contract enforcement (mon- itoring"); it also decides whether to lay o credit risk in order to release costly capital. A bank can lay o credit risk by either selling the loan or by buying insurance through a credit default swap (CDS). With a CDS, the originating bank retains the loan’s control rights but no longer has an incentive to monitor; with loan sales, control rights pass to the buyer of the loan, who can then monitor, albeit in a less-informed manner. In a single-period setting, for high levels

of base credit risk, only loan sales are used in equilibrium; risk transfer is e cient, but monitoring is excessive. For low levels of credit risk, equilibrium depends on the cost of capital shortfalls. When capital costs are low, only poor quality loans are sold or hedged; risk transfer is ine cient, and monitoring may also be too low. When capital costs are high, CDS and loan sales can coexist, in which case risk transfer is e cient but monitoring is too low. In both cases, if gains to monitoring are su ciently high, the borrowing rm may choose to borrow more than is needed to nance itself so as to induce monitoring. Restrictions on the bank’s ability to sell the loan expand the range where CDS are used and monitoring does not occur. In a repeated setting, reputation concerns may support e cient outcomes where CDS are used and the bank still monitors. Because loan defaults trigger a return to ine cient outcomes in the future, total e ciency cannot be sustained inde nitely. Reputational equilibria are most likely for rms that have high base credit quality or for rms where monitoring has a high impact on default probabilities. We have bene tted from helpful comments by Greg Nini and seminar participants at Lancaster, the University of Minnesota, Manchester Business School, HEC (Paris), NHH, UC Berkeley, and Wharton. yHaas School, UC Berkeley Tel: (510) 643-9391, E-mail: parlour@haas.berkeley.edu . zFinance Department, Carlson School of Management, University of Minnesota, 321 19th Avenue South, Minneapolis, MN 55455. Tel (612) 624-0589. E-mail: winto003@umn.edu. 1 1 Introduction Over the last fteen years, there has been a massive increase in the size of all types of markets for credit risk. Increasingly, a bank wishing to free up regulatory capital may either sell a loan directly or buy a synthetic product | a credit default swap (CDS) | that e ectively insures it against non-performance.1 As noted in the literature (which we review below), these markets allow risk transfer at the cost of reducing the monitoring incentives of the banks. There has been little work, however, on the tradeo s between loan sales and credit default swaps. Broadly, the di erence between the two is that in the former cash ows are bundled with control rights, in the latter they are not. Understanding which markets banks trade in is important for regulators trying to evaluate risk...

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