Optimal Credit Risk Transfer,

Monitored Finance, and Banks

Gabriella Chiesa

Department of EconomicsUniversity of Bologna

■ Loans held by banks until maturity/default risk-management tool: construction

of diversified portfolios☻ No discrepancy between real life and

banking paradigm (Diamond 84): Loans retention and diversification:debt-financed bks retain monitoring incentives:

perform delegated monitoring

bks keep being debt-financed

■ extensively engage in credit risk transfer (CRT):

- first traded in 96, CRT vol. $4.5 trill.;- CRT of unrated firms (bk m.) is steadily

increasing;-- portfolio products:

loan portfolio securitization: 26% of CRT

→ new pattern of financ. Intermediation: Originate-To-Distribute (OTD) model

Concern: mixed feelings about CRT

Buffett: CRT ↓ stability: • makes banks relinquinsh monit./screen

Greenspan: CRT has insulated bks and f.mkt from corporate failures (2000 US recession):

• merits of CRT as risk-management tool

Current credit mkt turmoil seems to support Buffett’s view and raise doubts about the provision of incentives underlying OTD model

Questions:• Is the OTD model necessarily harmful ? or are the CRT instruments used

distortionary?• If so why are they used?• What’s the role for prudential regulation?

Previous literature

CRT ↓ monit./screen. incentives.:

■ undermines the premise of financial stability

This paper revisits the issue

This paper

☻Optimal CRT ↑ ↑ monitoring:Maximizes incentive-based lending, for any

given bk capital ↑ financial intermediation and real invest

activity

by contrast to previous literature

☻ Optimal CRT instruments

• are based on loan portfolio and have

• credit-enhancement guarantees

pretty much as bks do in practice, but:

Credit enhancement

• needs to be precisely delimited: it must be within a defined interval.

Outside that interval, monitoring incentives are undermined -- the quality of assets that back CRT deteriorates

But do bks’ have incentives to engage in optimal CRT ?

• while insufficient credit-enhanc. is never profitable

(dilution of mon. inc. factored into the price of insuff. credit-enhanced securities)

• Excessive credit-enhanc. is profitable: wealth is transferred from bk’s financiers(tax payers via bail out) to the bk☻properly designed risk-based cap. requirements

are shown to restore efficiency making it profitable for bk to engage in optimal CRT

This paper’s message

• CRT as dynamite: very useful tool, if used properly

• Prudential regulation part of the conditions for proper use

w.r.t. current credit mkt turmoil:

• The problem is not that credit risk has been transferred (which indeed can be efficiency enhancing), but rather that it has been retained – via the (excessive) guarantees provided by the bks to the SIVs

Intuition

Bks raise outside finance via debt

• With debt, the better the outcome the greater the bk’s income;

• “high” outcomes may result from good luck rather than from monitoring: Debt rewards the bk for good luck rather than for monitoring

■ aggregate risk: loans are s.t. idiosyncratic risks and

common risk factor

(in line with the evidence: correlation of defaults is driven by the bus. cycle)

■ monitoring improves loan expected return, most valuable in downturns

We allow for

Bank’s action

Upturn: (p)

Downturn: (1-p)

m cost F

R Rprob.

Ø R R prob.

Project return distribution

■ monit.rev.outcomes are not “high” outcomes. High outcomes result from good luck rather than m:

Debt is suboptimal: it rewards good luck rather than m

a CRT arrang that reallocates bk’s income from lucky states to the monit.revealing states improves incentives

Capital per unit of lending lowers:Incentive-based lending expands:

Bk raises more funds, lends more, and still monitors

LmØ

K

Øm

K / c*

K/ cD

Incentive-Based Capacity

Lo

Ko

L*o

• Time inconsistency/commitment problem of hedging:

• after having borrowed funds and made loans, unregulated bk has the incentive to retain loan risk

→ role for prudential regulation: risk-based cap. req.

CRT is welfare improving…but bk must have the incentive to engage in optimal CRT

L

LD L*

m

crtnm

nm

K

Model

Bk funds lending out of internal funds (capital K) and outside finance. The supply of funds is perfectly elastic at a gross rate of return normalized to 1 (zero risk-free int.rate).

Lending consists in project financing.Project requires 1 unit at date 0 and delivers a return X{0,R} at date 1.

Success prob. depends on:• bk’s monit/non-monit. • Realization of a common risk factor

Sequence of events

Lending

m/Ø

Returnrealization

Returnrealization

Bank’s action

Upturn: (p)

Downturn: (1-p)

m(cost F)

R Rprob.

Ø R R prob.

[p+(1-p) ] R < 1; [p+(1-p) ]R >1+F

Project return distribution

Portfolio Outcomes

For a diversified portfolio, solvency rates = 1, ,

Highest outcome s=1 – “good luck” (upturn)

Monit.rev.outcome: s =

Optimal Contract

Maximizes bk’s profits:Maximizes outside finance, and hence bk

lending s.t. monit.inc.constraint and final investors’ part.constraint

☻ makes use of the information conveyed by loan portf.outcome and rewards the bk “as much as possible” for the outcomes that signal monitoring

Up-turn: Down-turn:

m 1W1

W

Ø 1W1

W (=0)

Bk penalized for nm

Contract (W1,W ,W)

Max [p W1+(1-p) W - FL-K ] s.t.

p W1+(1-p) W - FL-K > pW1-K (IC)

p(RL-W1)+ (1-p)( RL- W) = L- K (PC)

W1> W (MC)

Rearranging, the max. problem:

Optimal contract (W1,W )

Max L s.t.

L < [(1-p)/F] W (IC)

p(RL-W1)+ (1-p)( RL- W) = L- K (PC)

W1> W (MC) ■ maximizing profits amounts to max L. From

(IC) this amounts to maximizing the reward for monit. W, because of (PC) this requires minimizing the reward for good luck W1. At the optimum

W1= W

Prop.1 At the optimum, bk’s lending capacity is:

pFppc

cKL

1])1([1; *

**

Bank’s income:

KRppLWW 1)1(**1

*

Debt Financing

● Bk’s payoff sched. is a portf.outcome conting. sched. with W1> W

Monitoring is under-rewarded: ● incent.-based lending capacity ↓

*

**

1)1( c

pFRc

cKL

cKL

D

DD

LmØ

K

Øm

K / c*

K/ cD

Incentive-Based Capacity

Lo

Ko

L*o

• debt is suboptimal: rewards good luck

CRT is the tool for addressing the incentive distortion of debt financing.

Consider the arrangament:

(assuming Bk can commit to CRT)

CRT

1. The bank raises deposits L*-K and finances the optimal loan portfolio L*

2. It forms an SPV and securitizes/sells the loan portfolio for a total price P0

3. It credit-enhances the deal by giving investors the option to sell their claims back to the bank for a total price P. To back this guarantee, the bank injects P as cash collateral.

Prop 3 Any CRT mechanism (P*0 ,P*) with

RLPLpFRP

PPP

RLpRpLP

**

*

***0

;1

,

1

implements the optimal contract .

The bk’s income in securitization is the same as in the optimal contract:W1= W=L* {[p+(1-p) ]R-1}+K ; W=0

•Lending capacity is maximized

•Depositors and investors break-even

• All loans are monitored

Bk’s incentive for CRTPrudential Regulation

• Will the bk engage in optimal CRT, once the funds have been raised?

■ An unregulated bk profits by credit-enhancing the CRT deal excessively, to such an extent that effectively amounts to retaining the entire credit risk

L

LD L*

m

crtnm

nm

K

Prop. 4• A CRT mechanism backed by excessive credit-

enhancement undermines the bk’s monit.inc. and entails an ex post wealth transfer from depositors to the bk. A capital req. on loans conditioned on the extent of retained risk

RLPpcc LP *

/

Prevents such a wealth transfer, restoring efficiency

Results

☻ Risk Management: ↑↑ monitoring incentives:

more outside finance more lending and real investment

• Diversification: risk-management tool for

idiosyncratic risk;• Optimal CRT: risk-management tool for common risk

Results

• Optimal CRT based on loan portfolio and backed by a precise extent of credit-enhancement.

• Excessive cred-enhanc undermines monit (loan quality ↓) = ex post wealth transfer from depositors to the bk

• Risk-based capital req. provide bks with the incentive to engage in optimal CRT