The Role of Banks in Illiquid Credit Markets, and the Disruption and Evolution of Credit Portfolio Management

Amnon Levy and Pierre Xu

Throughout modern history, banks have dominated in extending illiquid credit, originating loans that reside on their books for years or, in some cases, decades. The resulting name and segment concentration poses severe challenges for banks as credit cycles inevitably turn, exposing them to significant risk of losses. With portfolio rebalancing generally managed through new origination, illiquidity can be crippling. Traditionally, credit risk has been managed through relationship banking; the use of stable, long-term relationships as a corporate governance mechanism, particularly when counterparties face performance issues, has long been standard practice (Petersen and Rajan 1994).

The environment has shifted, however. In this chapter we explore how the combination of new market entrants, new technologies and the (unintended) consequences of regulatory and accounting rules are driving banks to collect more data and to develop sophisticated tools when designing ever-more robust credit portfolio strategies. We also explore how these disruptions have given banks pause to reevaluate their pricing and market-segment focus, in some cases drastically altering the credit landscape.

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