In the latest years larger banks are steadily increasing their market share in credit risk transfer activities credit derivatives and loan sales as extensively documented by ECB (2004), BIS (2005), Minton et al. (2007) and Duffie (2007), among others. When transferring credit risk for risk management purposes, banks reduce their stake in the return from lending, impairing their incentives to monitor loans. If monitoring is important for bank credit, then credit risk transfer (CRT, hereafter) may reduce the value of intermediation and increase bank instability.
In addition, there is evidence that larger banks engaging in CRT transactions, participate in several markets at the same time (for instance Minton et al.(2007) find evidence that banks engaging in asset securitization are more likely to issue credit derivatives as well), showing that loan sales and credit derivatives are complementary activities, and that banks are on both sides of the market for credit derivatives as either buyers and sellers of protection (as documented by Allen and Carletti (2006) and Du¢ e (2007) among others).
The aim of this paper is to explore the impact of different CRT activities on bank monitoring incentives in a model where banks are subject to moral hazard and optimal capital regulation is in place. In the model loans face value may be reduced as a consequence of a shock. Banks are subject to a moral hazard problem: they have to exert unobservable efforts in order to monitor entrepreneurs in order to reduce their opportunism.
CRT activities have two different functions here: loan sales serve to free capital for new lending opportunities when other sources of funds are unavailable; credit derivatives instead provide insurance against loan losses. Given that the regulator's objective is to improve bank solvency and to avoid sub-optimal under-investment, the main result in the paper is that incentive compatible level of lending is achieved by letting banks to use a mix of loan sales and credit derivatives together with optimal capital regulation. More speci?fically, minimum capital requirements provide incentives, credit derivatives insure against shocks on loans value and loan sales provide ex-post liquidity for new lending opportunities once the bank has extended loans in the first stage up to the limit of capital requirements.