Risk Transfer with CDOs and Systemic Risk in Banking
32 Pages Posted: 20 Mar 2006
There are 2 versions of this paper
Risk Transfer with CDOs and Systemic Risk in Banking
Risk Transfer with Cdos and Systemic Risk in Banking
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: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
Innovations in Credit Risk Transfer: Implications for Financial Stability
-
Credit Derivatives, Disintermediation and Investment Decisions
-
Credit Risk Transfer and Contagion
By Franklin Allen and Elena Carletti
-
By Franklin Allen and Douglas M. Gale
-
Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis
-
Credit Risk Transfer and Financial Sector Performance
By Wolf Wagner and Ian W. Marsh
-
Credit Risk Transfer and Financial Sector Performance
By Wolf Wagner and Ian W. Marsh
-
Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations
By Guenter Franke and Jan Pieter Krahnen