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This paper investigates why banks use different credit risk transfer (CRT) instruments to hedge the credit risk of syndicated loans. We examine banks " decision to insure, sell or continue to hold a loan by considering the specific characteristics of both lenders and borrowers. We find that loans to borrowers with low credit quality are more likely to be sold in the secondary loan markets while loans to those with high credit quality are more likely to be hedged using credit default swaps, which are consistent with the predictions of theoretical literature. Interestingly, we find that bank lenders are more likely to use loan sales for low credit quality borrowers regardless of their binding financial or regulatory constraints. Additionally, we find that bank lenders are more likely to use CDS as a hedge instrument for relatively good quality borrowers especially if monitoring costs are relatively high. Finally, when we investigate reputable lenders with no financial and regulatory constraints, we find that these lenders are not significantly different from other lenders in choosing CRT instruments, which is inconsistent with the predictions of the theoretical literature.

Why and How Do Banks Lay Off Credit Risk?: The Choice between Loan Sales Versus Credit Default Swaps