Laying off Credit Risk: Loan Sales versus Credit Default Swaps

by Christine A. Parlour of the University of California, Berkley, and
Andrew Winton of the University of Minnesota

November 17, 2007

Abstract: We study the difference between loan sales and credit default swaps. After making a loan, a bank finds out if the loan needs contract enforcement ("monitoring") and if the bank should lay o the risk so as to release regulatory capital. A bank can lay off credit risk by either selling the loan or by buying insurance through a credit default swap (CDS). With a CDS, the originating bank retains the loan's control rights but no longer has incentive to monitor; with loan sales, control rights pass to the buyer of the loan, who can then monitor, albeit in a less-informed manner. For high levels of credit risk, only loan sales are used in equilibrium; risk transfer is efficient, but monitoring is excessive. For low levels of credit risk, CDS and loan sales may coexist, in which case risk transfer is efficient but there is no monitoring; in another equilibrium, only poor quality loans are sold, so risk transfer is inefficient while monitoring is optimal.

In a two period setting, a reputational equilibrium may be possible if credit risk is low, but not too low. In the first period, the bank uses CDS and efficient monitoring and risk transfer are achieved. In the second period, however, first period defaults are "punished" as noisy signals of shirked monitoring, with no use of CDS, inefficient risk transfer, and monitoring of sold loans.

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