Credit Risk Transfer

TLDR

Firms raise capital through banks and bonds, and banks can transfer credit risk to recycle capital or exploit private information, but the resulting market liquidity depends on trade motives and may not be socially optimal. The study examines how endogenous financial innovation influences relationship banking. The model yields testable predictions for credit derivative trading volumes and spreads, as well as loan and bond prices and quantities.

Abstract

We study the eect of endogenous financial innovation on relationship banking. Firms raise money from banks and the bond market. Banks may transfer credit risk in a secondary market to recycle their capital or to trade on private information. Liquidity in the credit risk transfer market depends on the relative likelihood of each motive for trade and aects firms’ optimal financial structure. Liquid credit risk transfer markets are not necessarily socially optimal. The model provides testable implications for trading volume and spreads in credit derivative markets, and prices and quantities in loan and bond markets.