The Effect of Credit Risk Transfer on Financial Stability

EUR Working Paper No. 21521 EN

24 Pages Posted: 8 Feb 2006  

Dirk G. Baur

University of Western Australia - Business School; Financial Research Network (FIRN)

Elisabeth Joossens

Joint Research Centre; Catholic University of Leuven (KUL)

Date Written: January 2006

Abstract

This paper shows under which conditions loan securitization, e.g. collateral debt obligations (CDOs) of banks can increase the systemic risks in the banking sector. We use a simple model to show how securitization can reduce the individual banks' economic capital requirements by transferring risks to other market participants and demonstrate that systemic risks do not decrease due to the securitization. Systemic risks can increase and impact financial stability in two ways. First, if the risks are transferred to unregulated market participants there is less capital in the economy to cover these risks. And second, if the risks are transferred to other banks interbank linkages increase and therefore augment systemic risks. We analyze the differences of CDOs (true sale) and credit default swaps (synthetic) in contributing to these risks. An empirical analysis finds a significant relationship between systemic risk and CDO issuance for monthly data for the years 2000 until 2005.

Keywords: CDOs, CDS, Systemic risk, financial stability, securitization, economic capital

JEL Classification: G21, G28

Suggested Citation

Baur, Dirk G. and Joossens, Elisabeth, The Effect of Credit Risk Transfer on Financial Stability (January 2006). EUR Working Paper No. 21521 EN . Available at SSRN: https://ssrn.com/abstract=881774 or http://dx.doi.org/10.2139/ssrn.881774

Dirk G. Baur (Contact Author)

University of Western Australia - Business School ( email )

School of Business
35 Stirling Highway
Crawley, Western Australia 6009
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Elisabeth Joossens

Joint Research Centre ( email )

Via E. Fermi 1
I-21020 Ispra (VA)
Italy

Catholic University of Leuven (KUL) ( email )

Oude Markt 13
Leuven, Vlaams-Brabant
Belgium

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