Moral Hazard and Adverse Selection in the Originate-to-Distribute Model of Bank Credit
Poole College of Management, NC State University
Case Western Reserve University - Department of Banking & Finance
February 25, 2009
Bank credit has evolved from the traditional relationship banking model to an originate-to-distribute model. We show that the borrowers whose loans are sold in the secondary market underperform their peers by about 9% per year (risk-adjusted) over the three-year period following the initial sale of their loans. Therefore, either banks are originating and selling loans of lower quality borrowers based on unobservable private information (adverse selection), and/or loan sales lead to diminished bank monitoring that affects borrowers negatively (moral hazard). We propose regulatory restrictions on loan sales, increased disclosure, and a loan trading exchange/clearinghouse as mechanisms to alleviate these problems.
Number of Pages in PDF File: 36
Keywords: Syndicated loans, Loan secondary market, Bank credit, Moral hazard, Adverse selection
JEL Classification: G12, G18, G21, G32
Date posted: October 28, 2008 ; Last revised: August 9, 2014
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