Screening and Monitoring of Corporate Loans

Abstract

How much of a loan should a lender dynamically retain and how does retention affect loan performance? We address these questions in a dynamic agency model in which a lender originates loans that it can sell to investors. The lender reduces default risk through screening at origination and monitoring after origination, but is subject to moral hazard. We show that the optimal lender-investor contract can be implemented by having the lender retain a stake in the loan that decreases over time, rationalizing loan sales after origination, and use the model to generate new predictions linking loan characteristics to initial retention, sales dynamics, and loan performance.

Keywords: Corporate loans, Moral Hazard, Securitization, CLOs, Debt Maturity, Dynamic Contracting