Optimal Risk Transfer, Monitored Finance and Real Investment Activity

Abstract

We examine the implications of (optimal) credit risk transfer (CRT) for bank-loan monitoring and financial intermediation. Loans are subject to idiosyncratic risks and to common risk factor. We find that: i) (optimal) CRT enhances loan monitoring and expands financial intermediation, by contrast to previous literature; ii) optimal CRT's reference asset is loan portfolio; in line with the large development of portfolio products. The intuition is that an optimal contract for the bank to raise finance makes use of the information conveyed by loan-portfolio outcome and rewards the bank as much as possible for the outcomes that signal monitoring: Conditional on monitoring, bank is insulated from exogenous risk (common factor): The amount of capital per lending unit it needs to inject to find it incentive-compatible to monitor attains the minimum; incentive-based lending capacity attains the maximum level. Deposit/debt financing is sub-optimal. It under-rewards monitoring: bank faces a tighter constraint on outside finance; incentive-based lending capacity is smaller. Optimal CRT amends to that: It makes use of the information conveyed by loan portfolio outcome so as to insulate monitoring bank from exogenous risk. Monitoring incentives are enhanced: incentive-based lending capacity attains the maximum. Loan competition is made fiercer: spreads fall, aggregate monitored finance and real investment activity expand. Bank excess return on capital and CRT activity are positively correlated.