Diamond (1984) showed that one of banks’ main functions and reasons for their existence is that they monitor the actions of their borrowers on behalf of the fund providers, the depositors. These because of free riding problems and excessive transaction costs can not undertake efficient monitoring themselves. The necessity of monitoring stems from the asymmetric distribution of information between banks and their debtors. Since the actions of a firm are not fully observable the firm may have incentives to undertake actions that are not desirable for a bank, i.e., actions that may increase the risk of non-repayment of the bank loan. To prevent their debtors from such actions banks monitor firms in order to induce them to behave in the way that is desirable for the bank.
But what happens if banks’ monitoring incentives are eroded, say, because banks do not carry the risk that a firm defaults on a loan anymore? Or to a lesser extent? Less or no monitoring incentives at all can be expected to reduce the level of monitoring a bank undertakes. A condition under which it would be of reduced value for a bank to monitor is given when a bank transfers the loan risk to a third party which, in turn, can not effectively induce the bank to exert the amount of monitoring the bank would have chosen if the loan risk had remained on the balance sheet of the bank. As markets for the transfer and trading of credit risk have greatly evolved over the past few years it has become feasible for banks to transfer the risk inherent in bank loans to third party investors, particularly to other banks and insurance companies.
In this paper we are interested in analyzing what effects credit risk transfer (CRT) has on the properties of financial intermediation, particularly the price of credit and the level of monitoring banks exert. Building on theoretical work by Rajan (1992) and particularly Holmstrom/Tirole (1997) we provide answers to the following two questions: a) What impact does the possibility of CRT have on the intensity with which banks monitor their debtors? and b) How does this affect the level of firm financing made available to firms in an economy?
As in Holmstrom/Tirole (1997) we first develop conditions under which it is feasible for a firm to be bank financed and assess the optimal amount of monitoring a bank exerts in this case. We then introduce the possibility for banks to transfer the credit risk of their loan engagements to a third party by means of exchanging parts of their assets with another bank. We show that such credit risk transfer indeed reduces a bank’s incentives to monitor its borrowers.
In addition, we investigate whether the possibility to transfer credit risk to third party banks has any impact on the overall volume of financing provided to firms in an economy. Our results indicate that this volume increases if there is the possibility to diversify the credit risk inherent in bank loans. This stands in contrast to what is often argued to be the effect of reduced monitoring, namely that, because of the heavier asymmetric distribution of information, there is less financing provided to firms.
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The effects of credit risk transfer on bank monitoring and firm financing
