Abstract - Solvency regulation and credit risk transfer

This paper explores the impact of different credit risk transfer (CRT) activities on the monitoring incentives of banks and the implications for solvency regulation. In a simple model where a banker might exert a monitoring effort in order to reduce entrepreneurs' opportunism, given that depositors cannot observe banker's effort, prudential regulation entails setting a minimum capital requirement and a fair deposit insurance premium. The role of CRT is explained once we add to this simple model a solvency shock and new lending opportunities: banks that have extended loans might be hit by an aggregate shock - corresponding to an economic downturn - negatively affecting future returns from loans; further, after the realization of the solvency shock, new lending opportunities occur. Given binding capital adequacy requirements, those opportunities cannot be pursued unless new liquidity is provided to the bank through access to financial markets. We show that the optimal solution can be implemented, in addition to new capital requirements and fair deposit insurance, through a combination of CRT instruments: loan sales to provide state-contingent liquidity and credit derivatives to insure loan losses. The tension between insurance and incentives is driving the results about optimal solvency regulation and use of CRT: when expected loan losses are dominant the bank must buy protection (sell CDS) to shed risk in downturns, while when the rate of growth of new lending opportunities is large the bank may even take on more risk (buy CDS) in downturns to be able to undertake expansion. Our simple model of prudential regulation shows that, when taking into account banker's incentives in the different states of the economy, capital requirements should not be designed with the unique objective to insure for loan losses in downturns but also with the concern for underinvestment in up-turns. We also confront the optimal solution to the alternative of hoarding liquidity at the initial stage in order to face latter lending opportunities and show that the solution with CRT is preferred as it entails lower capital ratios and greater lending. Our results find support in the empirical literature showing that 1) banks accessing CRT markets tend to increase their lending and hold less capital, 2) banks use both loan sales and credit derivatives at the same time, 3) banks are both buyers and sellers of protection in credit derivatives markets.

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