Laying Off Credit Risk: Loan Sales versus Credit Default Swaps

40 Pages Posted: 6 Sep 2008 Last revised: 28 Apr 2009

See all articles by Christine A. Parlour

Christine A. Parlour

University of California, Berkeley - Finance Group

Andrew Winton

University of Minnesota - Twin Cities - Carlson School of Management; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Date Written: April 23, 2009

Abstract

After making a loan, a bank finds out if the loan needs contract enforcement ("monitoring"); it also decides whether to lay off credit risk in order to release costly capital. A bank can lay off 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 efficient, 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 inefficient, and monitoring may also be too low. When capital costs are high, CDS and loan sales can coexist, in which case risk transfer is efficient but monitoring is too low. In both cases, if gains to monitoring are sufficiently high, the borrowing firm may choose to borrow more than is needed to finance 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 efficient outcomes where CDS are used and the bank still monitors. Because loan defaults trigger a return to inefficient outcomes in the future, total efficiency cannot be sustained indefinitely. Reputational equilibria are most likely for firms that have high base credit quality or for firms where monitoring has a high impact on default probabilities.

Keywords: loan sales, credit default swaps, credit risk, risk transfer, monitoring, banks

JEL Classification: G10, G20, G21

Suggested Citation

Parlour, Christine A. and Winton, Andrew, Laying Off Credit Risk: Loan Sales versus Credit Default Swaps (April 23, 2009). Available at SSRN: https://ssrn.com/abstract=1262885 or http://dx.doi.org/10.2139/ssrn.1262885

Christine A. Parlour

University of California, Berkeley - Finance Group ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
510-643-9391 (Phone)

Andrew Winton (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

321 19th Avenue South
Department of Finance
Minneapolis, MN 55455
United States
612-624-0589 (Phone)
612-626-1335 (Fax)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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