Optimal Credit Risk Transfer, Monitored Finance, and Banks
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Transcript of Optimal Credit Risk Transfer, Monitored Finance, and Banks
Optimal Credit Risk Transfer,
Monitored Finance, and Banks
Gabriella Chiesa
Department of EconomicsUniversity of Bologna
■ Loans held by banks until maturity/default risk-management tool: construction
of diversified portfolios☻ No discrepancy between real life and
banking paradigm (Diamond 84): Loans retention and diversification:debt-financed bks retain monitoring incentives:
perform delegated monitoring
bks keep being debt-financed
■ extensively engage in credit risk transfer (CRT):
- first traded in 96, CRT vol. $4.5 trill.;- CRT of unrated firms (bk m.) is steadily
increasing;-- portfolio products:
loan portfolio securitization: 26% of CRT
→ new pattern of financ. Intermediation: Originate-To-Distribute (OTD) model
Concern: mixed feelings about CRT
Buffett: CRT ↓ stability: • makes banks relinquinsh monit./screen
Greenspan: CRT has insulated bks and f.mkt from corporate failures (2000 US recession):
• merits of CRT as risk-management tool
Current credit mkt turmoil seems to support Buffett’s view and raise doubts about the provision of incentives underlying OTD model
Questions:• Is the OTD model necessarily harmful ? or are the CRT instruments used
distortionary?• If so why are they used?• What’s the role for prudential regulation?
Previous literature
CRT ↓ monit./screen. incentives.:
■ undermines the premise of financial stability
This paper revisits the issue
This paper
☻Optimal CRT ↑ ↑ monitoring:Maximizes incentive-based lending, for any
given bk capital ↑ financial intermediation and real invest
activity
by contrast to previous literature
☻ Optimal CRT instruments
• are based on loan portfolio and have
• credit-enhancement guarantees
pretty much as bks do in practice, but:
Credit enhancement
• needs to be precisely delimited: it must be within a defined interval.
Outside that interval, monitoring incentives are undermined -- the quality of assets that back CRT deteriorates
But do bks’ have incentives to engage in optimal CRT ?
• while insufficient credit-enhanc. is never profitable
(dilution of mon. inc. factored into the price of insuff. credit-enhanced securities)
• Excessive credit-enhanc. is profitable: wealth is transferred from bk’s financiers(tax payers via bail out) to the bk☻properly designed risk-based cap. requirements
are shown to restore efficiency making it profitable for bk to engage in optimal CRT
This paper’s message
• CRT as dynamite: very useful tool, if used properly
• Prudential regulation part of the conditions for proper use
w.r.t. current credit mkt turmoil:
• The problem is not that credit risk has been transferred (which indeed can be efficiency enhancing), but rather that it has been retained – via the (excessive) guarantees provided by the bks to the SIVs
Intuition
Bks raise outside finance via debt
• With debt, the better the outcome the greater the bk’s income;
• “high” outcomes may result from good luck rather than from monitoring: Debt rewards the bk for good luck rather than for monitoring
■ aggregate risk: loans are s.t. idiosyncratic risks and
common risk factor
(in line with the evidence: correlation of defaults is driven by the bus. cycle)
■ monitoring improves loan expected return, most valuable in downturns
We allow for
Bank’s action
Upturn: (p)
Downturn: (1-p)
m cost F
R Rprob.
Ø R R prob.
Project return distribution
■ monit.rev.outcomes are not “high” outcomes. High outcomes result from good luck rather than m:
Debt is suboptimal: it rewards good luck rather than m
a CRT arrang that reallocates bk’s income from lucky states to the monit.revealing states improves incentives
Capital per unit of lending lowers:Incentive-based lending expands:
Bk raises more funds, lends more, and still monitors
LmØ
K
Øm
K / c*
K/ cD
Incentive-Based Capacity
Lo
Ko
L*o
• Time inconsistency/commitment problem of hedging:
• after having borrowed funds and made loans, unregulated bk has the incentive to retain loan risk
→ role for prudential regulation: risk-based cap. req.
CRT is welfare improving…but bk must have the incentive to engage in optimal CRT
L
LD L*
m
crtnm
nm
K
Model
Bk funds lending out of internal funds (capital K) and outside finance. The supply of funds is perfectly elastic at a gross rate of return normalized to 1 (zero risk-free int.rate).
Lending consists in project financing.Project requires 1 unit at date 0 and delivers a return X{0,R} at date 1.
Success prob. depends on:• bk’s monit/non-monit. • Realization of a common risk factor
Sequence of events
Lending
m/Ø
Returnrealization
Returnrealization
Bank’s action
Upturn: (p)
Downturn: (1-p)
m(cost F)
R Rprob.
Ø R R prob.
[p+(1-p) ] R < 1; [p+(1-p) ]R >1+F
Project return distribution
Portfolio Outcomes
For a diversified portfolio, solvency rates = 1, ,
Highest outcome s=1 – “good luck” (upturn)
Monit.rev.outcome: s =
Optimal Contract
Maximizes bk’s profits:Maximizes outside finance, and hence bk
lending s.t. monit.inc.constraint and final investors’ part.constraint
☻ makes use of the information conveyed by loan portf.outcome and rewards the bk “as much as possible” for the outcomes that signal monitoring
Up-turn: Down-turn:
m 1W1
W
Ø 1W1
W (=0)
Bk penalized for nm
Contract (W1,W ,W)
Max [p W1+(1-p) W - FL-K ] s.t.
p W1+(1-p) W - FL-K > pW1-K (IC)
p(RL-W1)+ (1-p)( RL- W) = L- K (PC)
W1> W (MC)
Rearranging, the max. problem:
Optimal contract (W1,W )
Max L s.t.
L < [(1-p)/F] W (IC)
p(RL-W1)+ (1-p)( RL- W) = L- K (PC)
W1> W (MC) ■ maximizing profits amounts to max L. From
(IC) this amounts to maximizing the reward for monit. W, because of (PC) this requires minimizing the reward for good luck W1. At the optimum
W1= W
Prop.1 At the optimum, bk’s lending capacity is:
pFppc
cKL
1])1([1; *
**
Bank’s income:
KRppLWW 1)1(**1
*
Debt Financing
● Bk’s payoff sched. is a portf.outcome conting. sched. with W1> W
Monitoring is under-rewarded: ● incent.-based lending capacity ↓
*
**
1)1( c
pFRc
cKL
cKL
D
DD
LmØ
K
Øm
K / c*
K/ cD
Incentive-Based Capacity
Lo
Ko
L*o
• debt is suboptimal: rewards good luck
CRT is the tool for addressing the incentive distortion of debt financing.
Consider the arrangament:
(assuming Bk can commit to CRT)
CRT
1. The bank raises deposits L*-K and finances the optimal loan portfolio L*
2. It forms an SPV and securitizes/sells the loan portfolio for a total price P0
3. It credit-enhances the deal by giving investors the option to sell their claims back to the bank for a total price P. To back this guarantee, the bank injects P as cash collateral.
Prop 3 Any CRT mechanism (P*0 ,P*) with
RLPLpFRP
PPP
RLpRpLP
**
*
***0
;1
,
1
implements the optimal contract .
The bk’s income in securitization is the same as in the optimal contract:W1= W=L* {[p+(1-p) ]R-1}+K ; W=0
•Lending capacity is maximized
•Depositors and investors break-even
• All loans are monitored
Bk’s incentive for CRTPrudential Regulation
• Will the bk engage in optimal CRT, once the funds have been raised?
■ An unregulated bk profits by credit-enhancing the CRT deal excessively, to such an extent that effectively amounts to retaining the entire credit risk
L
LD L*
m
crtnm
nm
K
Prop. 4• A CRT mechanism backed by excessive credit-
enhancement undermines the bk’s monit.inc. and entails an ex post wealth transfer from depositors to the bk. A capital req. on loans conditioned on the extent of retained risk
RLPpcc LP *
/
Prevents such a wealth transfer, restoring efficiency
Results
☻ Risk Management: ↑↑ monitoring incentives:
more outside finance more lending and real investment
• Diversification: risk-management tool for
idiosyncratic risk;• Optimal CRT: risk-management tool for common risk
Results
• Optimal CRT based on loan portfolio and backed by a precise extent of credit-enhancement.
• Excessive cred-enhanc undermines monit (loan quality ↓) = ex post wealth transfer from depositors to the bk
• Risk-based capital req. provide bks with the incentive to engage in optimal CRT