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Why and How Do Banks Lay Off Credit Risk? The Choice between Loan Sales Versus Credit Default Swaps (Beyhaghi M., Massoud N.)

Bank Lending Bank Products and Diversification Risk-taking and Risk Management

Abstract

This paper investigates why banks use different credit risk transfer (CRT) instruments to hedge the credit risk of syndicated loans. We examine banks’ decision to insure, sell or continue to hold a loan by considering specific characteristics of both lenders and borrowers. We find that loans to borrowers with low credit quality are more likely to be sold in the secondary loan market while loans to those with high credit quality are more likely to be hedged using credit default swaps (CDS), especially when they face binding financial or regulatory constraints, which is consistent with the predictions of the theoretical literature. Interestingly, we find that bank lenders are more likely to use CDS as a hedge instrument, for relatively good quality borrowers, if monitoring costs are relatively high. Finally, our results show that CRT instruments are less likely to be used by reputable lenders for high quality borrowers.

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Libref/ Beyhaghi M., Massoud N. (2012) “Why and How Do Banks Lay Off Credit Risk? The Choice between Loan Sales Versus Credit Default Swaps”, Available at SSRN: http://ssrn.com/abstract=2049889
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