Credit risk transfer in U.S. commercial banks: What changed during the 2007–2009 crisis?

Credit Risk Hedging, Deposit Insurance Fund Protection, and Default Risk in Retail Banking during a Financial Crisis

“…If loan demand is relatively rate-elastic, a larger loan portfolio is possible at a reduced loan rate. Our findings are consistent with Pausch and Welzel (2012): a bank increases loan volume and decreases interest rate on loans as a reaction to a decrease in credit risk by hedging, and Bedendo and Bruno (2012): credit risk transfer practices (credit risk hedging in our model) increase loan risk taking. As the bank increases the credit risk hedging transaction, it also provides a return to a higher hedging cost base.…”

“…The first is the literature on credit risk transfer and banking stability, in which Duffie (2008), Bedendo and Bruno (2012), and Pausch and Welzel (2012) are major contributors. Duffie (2008) summarizes different aspects concerning credit risk transfer and on the whole takes a positive view: the principle benefits of credit risk transfer are earning-asset portfolio diversification and cost reduction of raising external capital for loan intermediation.…”

“…Duffie (2008) summarizes different aspects concerning credit risk transfer and on the whole takes a positive view: the principle benefits of credit risk transfer are earning-asset portfolio diversification and cost reduction of raising external capital for loan intermediation. Bedendo and Bruno (2012) document some potential beneficial effects of credit risk transfer on the economy since the funds released through credit risk transfer are subsequently invested by banks to sustain credit supply. Pausch and Welzel (2012) find that when capital adequacy regulation accepts credit default swaps as an instrument to mitigate credit risk, banks will engage in credit default swaps trading (Note 3).…”

“…Other examples are Maudos and de Guevara (2004), Williams (2007), Episcopos (2008), Bedendo and Bruno (2012), and Pausch and Welzel (2012). The fundamental insight shared by these papers is that conformity is generated by a design to distinguish oneself from the type with which one wishes not to be identified.…”

“…Wagner and Marsh (2006) also suggest that the incentive of banks to transfer credit risk is aligned with the regulatory objective of improving stability, and so the recent development of credit derivative instruments is to be welcomed. However, Bedendo and Bruno (2012) demonstrate that the contribution of credit risk transfer with credit swaps to the 2007-2009 financial turmoil has been widely debated. A common view argues that credit risk transfer practices spur excessive credit growth and increase risk taking as a result of reduced monitoring incentives in credit risk transfer users (Brunnermeier, 2009).…”