Why do banks with little skin in the game still monitor borrowers?
Bank lending to companies with iffy credit has more than doubled since the financial crisis. This is largely due to a ready market available for banks to offload their loans, reducing the risk carried on bank balance sheets. A yield-hungry institutional market in the age (until recently) of very low interest rates has been eager to buy up syndicated loans from less pristine, leveraged borrowers that pay higher yields. Leveraged loans now make up 43% of the syndicated loan market.
The evolution of the leveraged loan market from one in which banks held loans on their books to today’s model of packaging loans into marketable securities has come with a puzzling anomaly.
After a bank sells off most of a loan it originated, it would seemingly have less incentive to keep a close eye on the borrower, given that the bank’s exposure is fairly minimal; the salvage value in case of a default no longer justifies the costs incurred to perform credit monitoring. Yet that’s not what has happened. Banks have continued to ride herd on loans where they have little skin in the game.
In a working paper, University of Florida’s Sheila Jiang and Douglas Xu and UCLA Anderson’s Shohini Kundu offer up an intriguing explanation for why banks may be incentivized to invest resources into monitoring borrowers’ financials despite their minimal exposure: payoffs from renegotiation. The authors test this mechanism by examining a 2012 tax policy change.