Why and How Do Banks Lay off Credit Risk? The Choice between Retention, Loan Sales and Credit Default Swaps

Abstract

Banks have access to different markets for credit risk transfer (CRT), including the credit derivative and the secondary loan markets. We investigate how and why a bank chooses among these markets to hedge the credit risk of a loan. We find that banks with capital and liquidity constraints are more likely to use CRT instruments in general. Relationship lenders are more likely to hold loans on their balance-sheets and larger banks are more likely to use CRT markets than other banks, regardless of borrowers’ riskiness. We find lead banks are more likely to refrain from CRT activities than do other lending syndicate participants. Finally, we find a separating equilibrium in the CRT market: loans to ex-ante riskier borrowers are more likely to be sold and loans to safer borrowers are more likely to be hedged with CDS. We view credit derivatives and loan sales as joint choice variables in determining the hedging instrument to use.

Keywords: Credit Risk Transfer, Loan Sales, Credit Default Swaps, Financial and Regulatory Constraints

JEL Classification: G21, G32