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

68 Pages Posted: 19 Aug 2015 Last revised: 28 Jul 2016

See all articles by Mehdi Beyhaghi

Mehdi Beyhaghi

Federal Reserve Banks - Federal Reserve Bank of Richmond

Nadia Massoud

Melbourne Business School, University of Melbourne

Anthony Saunders

New York University - Leonard N. Stern School of Business

Date Written: February 8, 2016

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

Suggested Citation

Beyhaghi, Mehdi and Massoud, Nadia and Saunders, Anthony, Why and How Do Banks Lay off Credit Risk? The Choice between Retention, Loan Sales and Credit Default Swaps (February 8, 2016). 28th Australasian Finance and Banking Conference. Available at SSRN: https://ssrn.com/abstract=2645119 or http://dx.doi.org/10.2139/ssrn.2645119

Mehdi Beyhaghi

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Nadia Massoud (Contact Author)

Melbourne Business School, University of Melbourne ( email )

200 Leicester Street
Carlton, Victoria 3053 3186
Australia
+61 3 9349 8130 (Phone)
+61 3 9349 8136 (Fax)

HOME PAGE: http://mbs.edu/facultyresearch/facultydirectory/Pages/NadiaMassoud.aspx

Anthony Saunders

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
9-190, MEC
New York, NY 10012-1126
United States
212-998-0711 (Phone)
212-995-4220 (Fax)

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