Thursday, November 20, 2008

Moral Hazard and Adverse Selection in the O2D Model of Bank Credit

(Paper by Antje Berndt and Anurag Gupta) Over the last two decades, bank credit has evolved from the traditional relationship banking model to an originate-to-distribute model where banks can originate loans, earn their fee, and then sell them off to investors who desire such exposures. We show that the borrowers whose loans are sold in the secondary market under perform other bank borrowers by between 8% and 14% per year on a risk-adjusted basis over the three-year period following the sale of their loan. Furthermore, they suffer a value destruction of about 15% compared to their peers over the same period. This effect is more severe for small, high leverage, speculative grade borrowers. There are two alternative explanations for this underperformance - either banks are originating and selling bad loans based on unobservable private information, similar to the events in the current subprime mortgage crisis, and/or the severance of the bank-borrower relationship allows the borrowers to undertake suboptimal investment and operating decisions, in the absence of the discipline of bank monitoring. Our results also show that borrowers whose loans are not sold in the secondary market do not underperform their peers, reinforcing the inference that bank loan financing is indeed “special”, except for borrowers whose loans are sold. In light of these moral hazard and adverse selection problems, the originate-to-distribute model of bank credit may not entirely be “socially desirable”. We propose regulatory restrictions on loan sales, increased disclosure, and a loan trading exchange with a clearinghouse as mechanisms to alleviate these problems.

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