Credit Risk Transfer and Bank Lending

We study the difference between loan sales and credit default swaps. A bank lends money to an entrepreneur to undertake a positive NPV project. After the loan has been made, the bank finds out if the project benefits from monitoring and if it should sell the loan to release regulatory capital. A bank can lay off credit risk by either selling the loan or by buying credit insurance through a credit default swap. Finally, a bank holding a loan may monitor which in some cases increases the success probability. We characterize equilibria when banks choose how to lay off risk. We find that there there can be excessive monitoring if there are loan sales, and insufficient monitoring if there is both an active CDS and loan sale market. We find that an active CDS market makes loan prices less informative about the success probability of the project. Preliminary and Incomplete ∗We have benefitted from helpful comments by seminar participants . The current version of this paper is maintained at . †Haas School, UC Berkeley Tel: (510) 643-9391, E-mail: [email protected] . ‡Carlson School, U. Minnesota, E-mail: [email protected].