Banks' Loan Screening Incentives with Credit Risk Transfer: An Alternative to Risk Retention

Abstract

This article analyzes the impact of credit risk transfer on banks’ screening incentives on the primary loan market. While credit derivatives allow banks to transfer risk to investors, they negatively aect the incentive to screen due to the asymmetry of information between banks and investors. I show that screening incentives can be reestablished with standardized credit derivatives that fully transfer the underlying loan default risk. In particular, a callable credit default swap reveals a loan’s quality to the investor by letting him observe the bank’s readiness to pay for the implicit call feature. The ability to signal loan quality induces screening incentives. The paper also examines the impact of current developments such as higher regulatory capital standards, stricter margin requirements, and central clearing on the design of the optimal credit risk transfer contract.