Banks' Loan Screening Incentives with Credit Risk Transfer: An Alternative to Risk Retention

37 Pages Posted: 16 Apr 2014 Last revised: 18 Aug 2014

See all articles by Marc Arnold

Marc Arnold

University of St. Gallen - School of Finance; Swiss Finance Institute

Date Written: July 7, 2014

Abstract

This article analyzes the impact of credit risk transfer on banks' screening incentives on the primary loan market. While credit derivatives allow banks to transfer risk to investors, they negatively a ffect the incentive to screen due to the asymmetry of information between banks and investors. I show that screening incentives can be reestablished with standardized credit derivatives that fully transfer the underlying loan default risk. In particular, a callable credit default swap reveals a loan's quality to the investor by letting him observe the bank's readiness to pay for the implicit call feature. The ability to signal loan quality induces screening incentives. The paper also examines the impact of current developments such as higher regulatory capital standards, stricter margin requirements, and central clearing on the design of the optimal credit risk transfer contract.

Keywords: Credit Risk Transfer, Callable Credit Default Swaps, Screening Incentives

JEL Classification: G18, G28

Suggested Citation

Arnold, Marc, Banks' Loan Screening Incentives with Credit Risk Transfer: An Alternative to Risk Retention (July 7, 2014). University of St.Gallen, School of Finance Research Paper No. 2014/2, Available at SSRN: https://ssrn.com/abstract=2425096 or http://dx.doi.org/10.2139/ssrn.2425096

Marc Arnold (Contact Author)

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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