Lender Moral Hazard and Reputation in Originate-to-Distribute Markets

Abstract:     
We analyze a dynamic model of originate-to-distribute lending in which a bank with significant liquidity needs makes loans and then sells them in the secondary loan market. There is no uncertainty about the bank's monitoring ability or honesty, but the bank may not have incentives to monitor the loan after it has been sold. We examine whether the bank's concern for its reputation, which is based on the number of recent defaults on loans it has originated, can maintain its incentives to monitor. In equilibrium, a bank that has had more recent defaults obtains a lower secondary market price on its current loan and monitors less intensively. Monitoring is more likely to be sustainable if the bank has greater liquidity needs or monitoring has a higher benefit-to-cost ratio; reputation is more valuable for greater liquidity needs, higher monitoring benefit-to-cost ratio, and higher base loan quality. If the bank can commit to retaining part of loans it makes, then a bank with worse reputation retains more of its loan. Competition from a rival lender makes it less likely that monitoring can be sustained and may cause a high-reputation bank to cede the loan to the rival. A temporary increase in loan demand (a "lending boom") makes it less likely that any monitoring can be sustained, especially for low-reputation banks.

Number of Pages in PDF File: 43

Keywords: Monitoring, Reputation, Default

JEL Classification: G21, L14

working papers series