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The Effect of Credit Risk Transfer on Financial Stability

This paper shows under which conditions loan securitization, e.g. collateral debt obligations (CDOs) of banks can increase the systemic risks in the banking sector. We use a simple model to show how securitization can reduce the individual banks' economic capital requirements by transferring risks to other market participants and demonstrate that systemic risks do not decrease due to the securitization. Systemic risks can increase and impact financial stability in two ways. First, if the risks are transferred to unregulated market participants there is less capital in the economy to cover these risks. And second, if the risks are transferred to other banks interbank linkages increase and therefore augment systemic risks. We analyze the differences of CDOs (true sale) and credit default swaps (synthetic) in contributing to these risks. An empirical analysis finds a significant relationship between systemic risk and CDO issuance for monthly data for the years 2000 until 2005.