Optimal Risk Transfer, Monitored Finance and Real Investment Activity

36 Pages Posted: 20 May 2006

See all articles by Gabriella Chiesa

Gabriella Chiesa

University of Bologna - Department of Economics

Date Written: July 7, 2006

Abstract

We examine the implications of (optimal) credit risk transfer (CRT) for bank-loan monitoring and financial intermediation. Loans are subject to idiosyncratic risks and to common risk factor. We find that: i) (optimal) CRT enhances loan monitoring and expands financial intermediation, by contrast to previous literature; ii) optimal CRT's reference asset is loan portfolio; in line with the large development of portfolio products. The intuition is that an optimal contract for the bank to raise finance makes use of the information conveyed by loan-portfolio outcome and rewards the bank as much as possible for the outcomes that signal monitoring: Conditional on monitoring, bank is insulated from exogenous risk (common factor): The amount of capital per lending unit it needs to inject to find it incentive-compatible to monitor attains the minimum; incentive-based lending capacity attains the maximum level. Deposit/debt financing is sub-optimal. It under-rewards monitoring: bank faces a tighter constraint on outside finance; incentive-based lending capacity is smaller. Optimal CRT amends to that: It makes use of the information conveyed by loan portfolio outcome so as to insulate monitoring bank from exogenous risk. Monitoring incentives are enhanced: incentive-based lending capacity attains the maximum. Loan competition is made fiercer: spreads fall, aggregate monitored finance and real investment activity expand. Bank excess return on capital and CRT activity are positively correlated.

Keywords: Credit Risk Transfer, Monitoring Incentives, Competition, Prudential Regulation

JEL Classification: G21, D82, G28, D61

Suggested Citation

Chiesa, Gabriella, Optimal Risk Transfer, Monitored Finance and Real Investment Activity (July 7, 2006). EFA 2006 Zurich Meetings Paper. Available at SSRN: https://ssrn.com/abstract=903086 or http://dx.doi.org/10.2139/ssrn.903086

Gabriella Chiesa (Contact Author)

University of Bologna - Department of Economics ( email )

Piazza Scaravilli 2
40126 Bologna, 40126
Italy
+39-051-2095511 (Phone)
+39-051-2095510 (Fax)

HOME PAGE: http://www.dse.unibo.it/gchiesa/home.htm

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