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The Effect of Credit Risk Transfer on Financial StabilityDirk G. BaurUniversity of Technology, Sydney (UTS) - School of Finance and Economics; Financial Research Network (FIRN) Elisabeth JoossensJoint Research Centre; Catholic University of Leuven (KUL) January 2006 EUR Working Paper No. 21521 EN Abstract: This paper shows under which conditions loan securitization, e.g. collateral debt obligations (CDOs) of banks can increase the systemic risks in the banking sector. We use a simple model to show how securitization can reduce the individual banks' economic capital requirements by transferring risks to other market participants and demonstrate that systemic risks do not decrease due to the securitization. Systemic risks can increase and impact financial stability in two ways. First, if the risks are transferred to unregulated market participants there is less capital in the economy to cover these risks. And second, if the risks are transferred to other banks interbank linkages increase and therefore augment systemic risks. We analyze the differences of CDOs (true sale) and credit default swaps (synthetic) in contributing to these risks. An empirical analysis finds a significant relationship between systemic risk and CDO issuance for monthly data for the years 2000 until 2005.
Number of Pages in PDF File: 24 Keywords: CDOs, CDS, Systemic risk, financial stability, securitization, economic capital JEL Classification: G21, G28 working papers seriesDate posted: February 8, 2006Suggested CitationContact Information
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