Optimal Credit Risk Transfer, Monitored Finance, and Banks

1. Optimal Credit Risk Transfer, Monitored Finance, and Banks Gabriella Chiesa Department of Economics University of Bologna

2. ■ 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

3. 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

4. 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

5. 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?

6. Previous literature CRT ↓ monit./screen. incentives.: ■ undermines the premise of financial stability This paper revisits the issue

7. This paper ☻OptimalCRT ↑ ↑ monitoring: Maximizes incentive-based lending, for any given bk capital ↑ financial intermediation and real invest activity by contrast to previous literature

8. ☻ Optimal CRT instruments • are based on loan portfolio and have • credit-enhancement guarantees pretty much as bks do in practice, but:

9. 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

10. 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

11. This paper’s message • CRT as dynamite: very useful tool, if used properly • Prudential regulation part of the conditions for proper use

12. 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

13. 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

14. We allow for ■ 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

15. Project return distribution

16. ■ 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

17. Capital per unit of lending lowers: Incentive-based lendingexpands: Bk raises more funds, lends more, and still monitors

18. Incentive-Based Capacity L K / c* Ø m K/ cD Ø m L*o Lo Ko K

19. CRT is welfare improving …but bk must have the incentive to engage in optimal CRT • 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.

20. nm  crtnm m K L* LD L

21. Model • Bkfunds 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 returnX{0,R} at date 1. • Success prob. depends on: • bk’s monit/non-monit. • Realization of a common risk factor

22. Sequence of events Return realization  Lending m/Ø  Return realization

23. Project return distribution [p+(1-p) ] R < 1; [p+(1-p) ]R >1+F

24. Portfolio Outcomes For a diversified portfolio, solvency rate s = 1, ,  Highest outcome s=1 – “good luck” (upturn) Monit.rev.outcome: s = 

25. 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

26. Contract (W1,W ,W)

27. Optimal contract (W1,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:

28. 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 minimizingthe reward for good luckW1. At the optimum W1= W

29. Prop.1 At the optimum, bk’s lending capacity is: Bank’s income:

30. Debt Financing ● Bk’s payoff sched. is a portf.outcome conting. sched. with W1> W Monitoring is under-rewarded: ● incent.-based lending capacity ↓

31. Incentive-Based Capacity L K / c* Ø m K/ cD Ø m L*o Lo Ko K

32. 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)

33. 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.

34. Prop 3 Any CRT mechanism (P*0 ,P*) with implements the optimal contract .

35. 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

36. 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

37. nm  crtnm m K L* LD L

38. 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 Prevents such a wealth transfer, restoring efficiency

39. 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

40. 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