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Market discipline for financial institutions can be imposed not only from the liability side, as has often been stressed in the literature on the use of subordinated debt, but also from the asset side. This will be particularly true if good lending opportunities are in short supply, so that banks have to compete for projects. In such a setting, borrowers may demand that banks commit to monitoring by requiring that they use some of their own capital in lending, thus creating an asset market-based incentive for banks to hold capital. Borrowers can also provide banks with incentives to monitor by allowing them to reap some of the benefits from the loans, which accrue only if the loans are in fact paid o.. Since borrowers do not fully internalize the cost of raising capital to the banks, the level of capital demanded by market participants may be above the one chosen by a regulator, even when capital is a relatively costly source of funds. This implies that capital requirements may not be binding, as recent evidence seems to indicate. JEL Classification: G21, G38
Default risk sharing between banks and markets : the contribution of collateralized debt obligations
(2005)
This paper contributes to the economics of financial institutions risk management by exploring how loan securitization a.ects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction a bank retains through a first loss piece a very high proportion of the expected default losses, and transfers only the extreme losses to other market participants. The size of the first loss piece is largely driven by the average default probability of the securitized assets. If the bank sells loans in a true sale transaction, it may use the proceeds to to expand its loan business, thereby incurring more systematic risk. We find an increase of the banks' betas, but no significant stock price e.ect around the announcement of a CDO issue. Our results suggest a role for supervisory requirements in stabilizing the financial system, related to transparency of tranche allocation, and to regulatory treatment of senior tranches. JEL Klassifikation: D82, G21, D74 .