The rapid growth of the credit risk transfer market during recent years led to a paradigm shift in banking. Increasingly, the traditional “buy–and–hold” model of banking is transformed into a model where banks take an active approach to managing and trading credit risk exposures. Central to this process is the development of sophisticated credit risk transfer techniques, which allow banks to manage credit risk exposures in a more versatile manner.
The rapid growth of the credit derivatives market is particularly striking. In the US, for example, commercial banks’ credit derivative positions increased 15–fold over the period 1997 to 2003 (second quarter, Office of the Comptroller of the Currency 2003). Table 1 documents global credit derivative positions as of September 2003 (survey among 181 market participants).
According to this survey, the global banking industry used the credit derivative market to transfer USD 229 billion of credit risk out of the banking sector. Insurance and other non–bank companies sold USD 303 billion of net credit protection. This confirms the view that banks are net protection buyers in the credit derivatives market, while insurance and other non–bank companies are net protection sellers.
The surge of the credit derivatives market puts a challenge to the banking literature (see Gorton and Winton 2002 for a recent survey). Central to this literature is the idea that banks have a unique ability to build relationships with their borrowers, thus facilitating monitoring (Diamond 1984) and long–term commitment (Mayer 1990, von Thadden 1995). It is widely believed that credit risk transfers would impair these value–added functions of relationship lenders. For example, Gorton and Pennacchi (1995) argue that credit risk transfers in the form of loan sales can reduce banks’ incentive to engage in loan value enhancement (“monitoring”) efforts.
The idea is that if a bank reduces its exposure to a borrower it will care only about the retained fraction of the loan, thereby dampening its incentive to exert efficient monitoring effort. This reasoning seems to support the view that banks’ recent embracement of credit derivatives may impose a threat to the viability of relationship banking.
The present paper argues that this view is incomplete. It neglects that credit derivatives differ in important ways from first generation risk transfer instruments, such as loan sales. Typically, when a bank sells a loan, it will be no longer exposed to the credit risk stemming from the loan. Likewise, when a bank sells part of the loan, it will exposed only the credit risk stemming from the retained portion of the loan.
Credit derivatives instead facilitate temporary transfers of credit risk. This is because credit derivatives allow banks to transfer credit risks without having to remove core assets from their balance sheets. At the same time, credit derivatives can be structured in terms of maturity. In particular, they can have (and frequently do have) maturities shorter than those of the underlying loans, thus allowing banks to take temporary protection against losses.
This paper proposes a theory of credit protection and bank oversight in the corporate loan market that builds on these unique features of credit derivatives. Our main finding is that properly devised credit protection facilitates the management of client relationships in banks’ core loan business, thereby fostering value creation in the corporate loan market (and relaxing bank monitoring incentive constraints).
While somewhat paradoxical at first sight, the intuition behind this result is simple: Credit protection improves banks’ exit option in the event of poor performance on the side of corporate borrowers, thus strengthening their commitment to engage in timely intervention. This in turn has positive implications for corporate managerial incentives.5 Put differently, credit protection makes it less costly for a bank to penalize a borrower for poor performance (by forcing the firm into early bankruptcy and liquidation), which provides the borrower with an additional incentive to exert effort.
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