Credit Risk Transfer in Banking Markets with Hard and Soft Information†

We consider a banking model in which firms’ access to credit is constrained due to the banks’ limited risk-bearing capacities. We show that such constraints may be relaxed by allowing banks to transfer risks to outside investors. However, the market for credit risk transfer (CRT) works smoothly only if loans are based on hard, i. e., verifiable information. In contrast, the market for CRT either breaks down or operates at a comparably low scale for soft-information loans. The reason is that banks have an incentive to grant loans with negative NPV and transfer the risks to other parties, which leads to a lemons premium for CRT. In comparison to the hard-information case, the access to finance in the economy improves only slightly, but aggregate risk increases.