The FED Was Right: Lessons from Credit Risk Transfer in the US during the Financial Crisis
Credit risk transfer (CRT) tools, including loan sales, securitization and credit derivatives, turned out to be an effective way for the American banks to raise financial resources to be channelled into loans during the 2007-2009 crisis, vindicating regulators' decision to approve emergency measures aimed at preserving sufficient liquidity in CRT markets, and raising some doubts about post-crisis, excessively restrictive regulation.
Mascia Bedendo and Brunella Bruno (both Department of Finance) in Credit Risk Transfer in US Commercial Banks: What Changed during the 2007-2009 Crisis? (Journal of Banking and Finance, Vol. 36, Issue 12, December 2012, Pages 3260-3272, doi: 10.1016/j.jbankfin.2012.07.011) collect evidence showing that the funds released through CRT have been subsequently invested by banks to sustain credit supply even in recession, "which suggests that the measures aimed at preserving CRT liquidity have been beneficial to the real economy in terms of lower credit contraction". The flip side is higher riskiness and higher default rates in recession for the banks more involved in loan sales and securitization.
In a fine-grained analysis, Bedendo and Bruno investigate the use and effects of CRT activities both in the years leading up to the financial crisis and during the crisis; consider the whole range of CRT tools available to US commercial banks; and observe the results both for medium-sized (total assets between $ 1 billion and $ 20 billion) and large banks (total assets in excess of $ 20 million). Using data from the Consolidated Reports of Condition and Income (Call Reports), they find that 70% of US commercial banks use CRT tools (the percentage increases to 90% for large banks), with 80% of the users employing just one tool and only 5-6% of them using all the three tools.
The scholars document that the contraction in CRT during the crisis has been more severe for medium-sized than for large banks and that the tool that suffered more has been securitization, due to the uncertainty surrounding the evaluation of asset-backed securities. This has been partly balanced by outright asset sales, "which represent a cheaper, more flexible, and more transparent alternative to transfer credit risk", the authors write.
While the data confirm that the resources generated via CRT have been invested to boost bank loans, this effect has been evident during the crisis only for business and consumer loans, due to the drying up of the mortgages market after the burst of the real estate bubble. Furthermore, all the documented effects are stronger for the so-called funded tools (loan sales and securitization, which generate cash in contrast with credit derivatives, which enable banks to release capital, but don't generate cash). The use of credit derivatives for hedging (documented for large banks) has not produced detrimental effects on bank stability.
"Our results suggest that the principal incentive driving CRT during the credit crunch is the need to raise additional financial resources (and that) the financial resources released through CRT have been invested to expand bank lending not only in good times but also, to a lesser extent, during the crisis", the scholars write. "The effects of CRT on credit supply and bank risk, however, vary across different CRT instruments, since they turn out to be much stronger for funded tools than for credit derivatives".
The authors conclude with a remark about the post-crisis regulatory interventions, claiming that "some of the new rules may excessively undermine the demand for CRT. This is the case, for example, with the new Basel III framework, whose stricter capital, liquidity and leverage requirements may actually lead to excessive downsizing of CRT".