Moral Hazard and Adverse Selection in the Originate-to-Distribute Model of Bank Credit

Abstract

Bank credit has evolved from the traditional relationship banking model to an originate-to-distribute model. We show that the borrowers whose loans are sold in the secondary market underperform their peers by about 9% per year (risk-adjusted) over the three-year period following the initial sale of their loans. Therefore, either banks are originating and selling loans of lower quality borrowers based on unobservable private information (adverse selection), and/or loan sales lead to diminished bank monitoring that affects borrowers negatively (moral hazard). We propose regulatory restrictions on loan sales, increased disclosure, and a loan trading exchange/clearinghouse as mechanisms to alleviate these problems.

Keywords: Syndicated loans, Loan secondary market, Bank credit, Moral hazard, Adverse selection

JEL Classification: G12, G18, G21, G32