Risk Transfer with CDOs and Systemic Risk in Banking

32 Pages Posted: 20 Mar 2006

See all articles by Jan Pieter Krahnen

Jan Pieter Krahnen

Goethe University Frankfurt

Christian Wilde

Goethe University Frankfurt - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: June 5, 2006

Abstract

Large banks often sell part of their loan portfolio in the form of collateralized debt obligations (CDO) to investors. In this paper we raise the question whether credit asset securitization affects the cyclicality (or commonality) of bank equity values. The commonality of bank equity values reflects a major component of systemic risks in the banking market, caused by correlated defaults of loans in the banks' loan books.

Our simulations take into account the major stylized fact of CDO transactions, the non-proportional nature of risk sharing that goes along with tranching. We provide a theoretical framework for the risk transfer through securitization that builds on a macro risk factor and an idiosyncratic risk factor, allowing an identification of the types of risk that the individual tranche holders bear. This allows conclusions about the risk positions of issuing banks after risk transfer.

Building on the strict subordination of tranches, we first evaluate the correlation properties both within and across risk classes. We then determine the effect of securitization on the systematic risk of all tranches, and derive its effect on the issuing bank's equity beta. The simulation results show that under plausible assumptions concerning bank reinvestment behaviour and capital structure choice, the issuing intermediary's systematic risk tends to rise. We discuss the implications of our findings for financial stability supervision.

Keywords: Banking, risk transfer, systematic risk, systemic risk

JEL Classification: G28, G21

Suggested Citation

Krahnen, Jan Pieter and Wilde, Christian, Risk Transfer with CDOs and Systemic Risk in Banking (June 5, 2006). CFS Working Paper No. 2006/04, EFA 2007 Ljubljana Meetings Paper, Available at SSRN: https://ssrn.com/abstract=889541 or http://dx.doi.org/10.2139/ssrn.889541

Jan Pieter Krahnen (Contact Author)

Goethe University Frankfurt ( email )

Gr├╝neburgplatz 1
Frankfurt am Main, 60323
Germany

Christian Wilde

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Grueneburgplatz 1
Frankfurt am Main, Hessen 60323
Germany

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