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(Commercial & Investment Banking) Topic: Discuss the disadvantages and advantages of "loan sales" as part of managing the credit risk of a Financial Institution Introduction A loan sale is a kind of sale from bank, according to the contract of all or part of the cash stream with specific loan. FIS can reduce credit risk completely through removing the loan from the balance sheet allowed by loan sales. When an FI makes a loan and sells it to outside buyers, with or without recourse. If a loan is sold without recourses, it will removed from the FI’s balance sheet and the FI has no obvious obligation if the loan eventually goes bad. There are three parts of the U.S. loan sales market : two sales of domestic loans—traditional short-term loan sales and highly leveraged transaction (HLT) loan sales1. In addition, there is an emerging market loan sales and trading. loan sales are increasingly being recognized as a valuable additional tool in an FI's portfolio of credit risk management techniques although loan sales have existed for many years. In fact, new loan announcements have been found to be positively correlated with a positive stock price announcement even when a borrower deals with a loan trade on the secondary market. In addition, when the borrower's existing loan deals for the first time in the secondary loan market, it elicited a positive reaction in share prices2. This report aims to illustrate the disadvantages and advantages of "loan sales" as part of managing the credit risk of a Financial Institution. Finally, the article will end this paper with the critical thinking. Advantages and Disadvantages of Loan sales Selling off a loan to another lender allows the seller bank to improve their short-term liquidity position. When a loan or part of loan is sold from one bank to another, the buyer bank/FI purchases the loan in exchange for cash or liquid funds. The seller bank can then use these funds received from loan sales for multiple purposes like awarding loans to new customers which will boost the bank’s revenues. The seller bank can also utilize the proceeds to pay off its obligations which will improve the liquidity too. Additionally, loan sales also help the seller bank to reduce its risk since by selling the loan the risk associated with customer default also gets transferred to the buyer bank. A major disadvantage of selling loan is that the company is deprived of revenue it would have generated throughout the tenure of the loan in case the loan has stayed with the bank. The seller bank in most cases would sell the loan at a discount which further reduces the return that could have been received had the loan resided on its financial statements. There is also a huge possibility that to gain immediate liquidity, the seller bank might unload some good quality loans and preserve the bad-quality ones in its portfolio of loans (more, 2021 and (2021)). The strength of loan sales comes from the way they deal with risk, which is more efficient than conventional lending. Generally speaking, there are two main sources of risk in lending. [footnoteRef:1]First, the borrower does not pay the principal and interest on time, or evades the credit risk brought by the debt. Second, the gap between the interest rate and maturity of assets and liabilities will bring uncertainty to banks' earnings. [1: Rustom,M. and Ralf,R. (2017). Loan Sales and Bank Liquidity Management: Evidence from a U.S. Credit Register. Review of Financial Studies. Oct2017, Vol. 30 Issue 10, p3455-3501. 47p. ] Loan sales increase the transparency of risk and allocate it to the trading parties that are best placed to bear it. First, under traditional lending, all risks are bundled together, and loan originators try to minimize credit risks in three stages: pre-loan investigation, loan review, and post-loan inspection. Using one's full good standing and credit to guarantee one's own debt, it creates a barrier between savers and borrowers, and the originator alone bears whatever risks the loan entails. Shareholders' higher return expectations raise the cost of equity. However, loan sales, due to its excellent risk management, greatly reduces the uncertainty and borrowing costs caused by asset concentration and non-credit losses, enriches the theory of liquidity management and provides a new perspective for resolving liquidity risks. Second, loan sales insulate loans from the balance sheet of the originators, who do not bear all the risk, and interest rate risk is allocated on a tailor-made basis and passed on to the investors best placed to bear it. Credit risk is divided into two "vertical" segments: the first segment refers to the normal credit risk, which is assumed by the lender, because the originator has a direct connection with the borrower and has advantages in information, technology and talent in a certain area and industry. The second credit risk is borne by the buyer who sells the loan. Conclusion After analyzing the advantages and drawbacks of the loan sale, we can not deny the fact that it is a useful instrument to transfer credit risk from the banks to buyer institutions, especially for those with capital and liquidity constraints. In fact, except for loan sales, the banks can manage credit risk by other choices, such as retention or credit default swaps (CDS). The dramatic growth and popularity of the credit-derivative and the loan-sale markets have equipped the banking industry with a variety of mechanisms to hedge credit risk. Figure1. Aggregate market size of two credit risk transfer market: loan sale market and CDS market (in billions of U.S. dollars) Source: Loan Pricing and Trading Corporation & International Swaps and Derivatives Association’s Market Survey The figure above shows that the national value of the CDS market tends to grow explosively in the past decade and have much greater market size compared to loan sale market. In 2007, the CDS market value went to its peak at approximately $62.2 trillion, which was even larger than the size of the world economy (GDP about $60 trillion) in that year (#1). Although the use of tools such as loan-sale and CDS could facilitate risk management more efficiently, they also have created concerns. This is because these instruments themselves generate potential moral hazard incentives, in which lenders may issue low-quality loans if they do not need to keep borrower’s credit risk on their balance sheets. Reference Beyhaghi, M., Massoud, N. and Saunders, A. (2017) ‘Why and how do banks lay off credit risk? The choice between retention, loan sales and credit default swaps’, Journal of Corporate Finance, 42, pp. 335–355. doi: 10.1016/j.jcorpfin.2016.12.006. 1 Fdic.gov. 2021. FDIC: Loan Sales Announcements & FAQs. [online] Available at:
[Accessed 18 April 2021]. 2 Saunders, A., Cornett, M. M., & Erhemjamts, O. (2021). Financial institutions management: A risk management approach. New York, NY: McGraw-Hill Education.