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Credit Risk Transfer: To Sell or to Insure

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  • James R. Thompson

    ()
    (Queen's University)

Abstract

This paper analyzes credit risk transfer in banking. Specifically, we model loan sales and loan insurance (e.g. credit default swaps) as the two instruments of risk transfer. Recent empirical evidence suggests that the adverse selection problem is as relevant in loan insurance as it is in loan sales. Contrary to previous literature, this paper allows for informational asymmetries in both markets. We show how credit risk transfer can achieve optimal investment and minimize the social costs associated with excess risk taking by a bank. Furthermore, we find that no separation of loan types can occur in equilibrium. Our results show that a well capitalized bank will tend to use loan insurance regardless of loan quality in the presence of moral hazard and relationship banking costs of loan sales. Finally, we show that a poorly capitalized bank may be forced into the loan sales market, even in the presence of possibly significant relationship and moral hazard costs that can depress the selling price.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1131.pdf
File Function: First version 2007
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Bibliographic Info

Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1131.

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Length: 42 pages
Date of creation: Jun 2007
Date of revision:
Handle: RePEc:qed:wpaper:1131

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Keywords: credit risk transfer; banking; loan sales; loan insurance; credit derivatives;

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References

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  1. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January.
  2. Minton, Bernadette A. & Stulz, Rene M. & Williamson, Rohan, 2005. "How Much Do Banks Use Credit Derivatives to Reduce Risk?," Working Paper Series 2005-17, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  3. Sandeep Dahiya & Manju Puri & Anthony Saunders, 2003. "Bank Borrowers and Loan Sales: New Evidence on the Uniqueness of Bank Loans," The Journal of Business, University of Chicago Press, vol. 76(4), pages 563-582, October.
  4. Gregory R. Duffee & Chunsheng Zhou, 1997. "Credit derivatives in banking: useful tools for managing risk?," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1997-13, Board of Governors of the Federal Reserve System (U.S.).
  5. Acharya, Viral V & Johnson, Tim, 2005. "Insider Trading in Credit Derivatives," CEPR Discussion Papers 5180, C.E.P.R. Discussion Papers.
  6. Guillaume Plantin & Christine A Parlour, . "Credit Risk Transfer," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 2005-E45, Carnegie Mellon University, Tepper School of Business.
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Citations

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Cited by:
  1. Stephens, Eric & Thompson, James R., 2014. "CDS as insurance: Leaky lifeboats in stormy seas," Journal of Financial Intermediation, Elsevier, vol. 23(3), pages 279-299.
  2. Batchimeg Sambalaibat, 2012. "Credit Default Swaps and Sovereign Debt with Moral Hazard and Debt Renegotiation," 2012 Meeting Papers, Society for Economic Dynamics 1093, Society for Economic Dynamics.
  3. James R. Thompson, 2007. "Counterparty Risk in Insurance Contracts: Should the Insured Worry about the Insurer?," Working Papers, Queen's University, Department of Economics 1136, Queen's University, Department of Economics.
  4. Finn Poschmann, 2011. "What Governments Should Do in Mortgage Markets," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 318, January.
  5. Parlour, Christine A. & Winton, Andrew, 2013. "Laying off credit risk: Loan sales versus credit default swaps," Journal of Financial Economics, Elsevier, vol. 107(1), pages 25-45.

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