Credit Risk Transfer: To Sell or to Insure

Abstract

This paper analyzes credit risk transfer in banking. Specifically, we model loan sales and loan insurance (e.g. credit default swaps) as the two instruments of risk transfer. Recent empirical evidence suggests that the adverse selection problem is present in loan insurance as well as loan sales. Contrary to previous literature, this paper allows for informational asymmetries in both markets. Our results show that a bank with a low cost of capital will tend to use loan insurance regardless of loan quality in the presence of moral hazard and relationship banking costs of loan sales. Conversely, a bank with a high cost of capital may be forced into the loan sales market, even in the presence of possibly significant relationship and moral hazard costs that can depress the selling price. We show how credit risk transfer can lead to the efficient investment decision, but that there exists a parameter range in which it improves the investment decision only in banks with low quality loans. Furthermore, even under perfect information, the benefits of credit risk transfer are shown to be at least as high, or higher for banks with low quality loans.

Keywords: credit risk transfer, asymmetric information, banking, loan sales, loan insurance

JEL Classification: G21, G22, D82