Bank loan credit risk pooling: risk diversification versus the moral hazard problem

Abdulali Hadizada

Abstract

Banks aim to manage their exposure to credit risk (which consists of default risk and recovery risk) with credit risk transfer instruments such as loan sales and credit derivatives. Credit risk pooling, with which banks pool their loans together and share the credit returns, is an alternative to credit risk transfer. Both credit risk transfer and credit risk pooling result in a trade-off between the benefits of risk transfer/sharing and the adverse effects of the moral hazard problem (that is, diminished incentives to monitor loans for which the credit risks have been completely or partially transferred outside the bank). This paper presents a credit risk pooling arrangement that not only eliminates the moral hazard problem associated with credit risk sharing but also improves the risk–return profiles of all the participating banks via diversification of recovery risk. The diversification effect of pooling reduces the probability of bank failure for each participating bank.