Recent innovations in the credit derivatives market have improved lenders' ability to transfer credit risk to other institutions while maintaining their relationship with their customers. Such innovations have generally received a guarded welcome from supervisory authorities and policymakers, who recognize the benefits of allowing risk to reside in separate institutions from the loan originators. The benefits of diversification are widely thought to be significant, even though it not always easy to identify, let alone measure the extent of, these benefits. Despite these widely recognized benefits, the welcome has been guarded at least in part because policymakers are concerned that credit derivatives create moral hazard problems associated with asymmetric and hidden information. The relevant research has emphasized these incentive problems from two distinct angles. First of all, an incentive problem can arise if the lender purchases credit protection against the wishes of the borrower or without informing the borrower. In this case the purchase of the credit protection may send a negative signal about the borrower.
Secondly, the incentive problem can arise on the borrower side of the relationship. In the absence of well-functioning credit risk transfer markets, lenders will monitor borrowers and force them to choose and continue to run only first-best projects. This bank certification signals the borrower's quality to the market, allowing the borrower to combine costly loan finance with cheaper bond finance. If the borrower's equity is traded, the signal should also increase the stock price. However, when there are well-functioning credit risk transfer markets, reducing bank monitoring by insured lenders will reduce the value of bank certification. The equilibrium outcome may be that borrowers no longer want to pay a premium for bank certification and run first-best projects, but instead issue bonds and run second-best projects.
On the other hand, there are studies arguing that credit risk transfer can enhance monitoring incentives, eg by making banks act in a tougher manner. Banks can also use portfolio credit risk transfers to reduce their exposure to the common factor in credit risk and retain idiosyncratic risk. Banks are rewarded for monitoring these risks, and, since the common factor in risk is removed, it now costs less capital to engage in monitoring. For a fixed amount of capital, monitored lending now increases following credit risk transfer, and there is some empirical evidence to support this theoretical implication.
In his empirical study 'The effect of lenders' credit risk transfer activities on borrowing firms' equity returns' (BoF 31/2006) Ian Marsh examines to what extent borrowers benefit from bank certification when banks have access to credit risk transfer mechanisms. Methodologically, the study belongs to the class of event studies and the data set consists of press releases from the Factiva database over the years 1999–2005 containing news of new loans by companies traded on the New York Stock Exchange. The set of press releases has been cleaned for various reasons, after which the author's data set consists of 271 'clean' press releases of new loan announcements. In line with the literature on the effects of new loan announcements on stock market prices, Marsh tests whether lenders' activities in credit risk transfer markets affect stock market reactions to announcements of new loans by these lenders.
According to the estimation results, when the lending banks actively manage their credit risk exposure through large-scale securitization programmes, the reaction of stock market prices to loan announcements by these banks is statistically insignificant. If, on the other hand, a firm obtains a loan from an otherwise equivalent bank that does not issue credit risk transfer instruments, the data flags a statistically significant increase in the firm's stock price. Consequently, Marsh's results seem to lend support to the idea that the equity market does not appear to place any value on news of loans extended by banks that are known to transfer credit risk off their books.
This is an interesting result and is not inconsistent with the view that the equity market believes that the use of large scale securitization programmes for credit risk management weakens banks' monitoring incentives. The combination of this result with the evidence that banks that adopt credit risk management techniques also expand their loan portfolios can fuel the type of unstable financial market dynamics about which the famous financial historian Charles Kindleberger has so enthusiastically written: 'excessive and unmonitored credit expansion can defy financial market stability and precipitate financial market manias that lead to market panics and crashes'. It is clear that Marsh's results and, more generally, research on credit risk transfer markets are highly relevant from the point of view of central banks and financial supervision authorities. Further research on this issue is, consequently, also needed in the future. |