Moral Hazard and Adverse Selection in the Originate-To-Distribute Model of Bank Credit | Weatherhead

Moral Hazard and Adverse Selection in the Originate-To-Distribute Model of Bank Credit

Posted 4.27.2010

Moral Hazard and Adverse Selection in the Originate-To-Distribute Model of Bank Credit

The historic credit crisis of 2007-2008 brought an important question sharply into focus—to what extent should bank credit be allowed to evolve from its traditional relationship banking model to the transaction-oriented model that has largely emerged over the last two decades? This fundamental shift in banking has been due to the explosive growth in the secondary syndicated loan market. The presence of this market transforms bank credit to an "originate-to-distribute" model, where banks can originate loans, earn their fees, and then distribute them to other investors in a largely opaque manner.

This shift to the "originate-to-distribute" model of bank credit has important implications for all market participants, including the originating banks, the participating loan investors, the borrowing firms, and the regulators. The banks’ superior information about their borrowers gives rise to concerns about adverse selection—are the banks selling off loans about which they have negative private (unobservable) information? In a perfect market, this should lead to a breakdown of the secondary loan market due to the classic "lemons" problem. The issue of adverse selection is important from the perspective of the participating loan investors as well — can they trust that the bank selling the loan is doing so due to legitimate motives (like capital relief and risk management) rather than due to negative private information? Alternatively, does it lead to moral hazard in terms of impairment in the monitoring function of banks, thereby having a negative effect on the borrowers?

Associate Professor of Banking and Finance Anurag Gupta, PhD, shows that the borrowers whose loans are sold in the secondary market underperform their peers by about 9 percent per year (risk adjusted) over the three-year period following the initial sale of their loans. As a result, either banks are originating and selling loans of lower quality borrowers based on unobservable private information (adverse selection), and(or) loan sales lead to diminished bank monitoring that affects borrowers negatively (moral hazard). Based on their findings, Dr. Gupta and his collaborator, Antje Berndt from Carnegie Mellon University, propose regulatory restrictions on loan sales, increased disclosure, and a loan trading exchange/clearinghouse as mechanisms to alleviate these problems.

Gupta’s research received extensive media coverage including an article in the Wall Street Journal, a live television interview on CNBC’s Squawk Box, and coverage on NPR’s Marketplace, among others.

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