Theoretical Economics Letters, 2011, 1, 81-87
doi:10.4236/tel.2011.13017 Published Online November 2011 (http://www.SciRP.org/journal/tel)
Copyright © 2011 SciRes. TEL
Syndication and Secondary Loan Sales*
Paolo Colla1, Filippo Ippolito2,3
1Department of Finance, Universitá Bocconi, Milan, Italy
2Department of Economics and Business, Universitat Pompeu Fabra, Barcelona, Spain
3Barcelona Graduate School of Economics, Barcelona, Spain
E-mail: paolo.colla@unibocconi.it, filippo.ippolito@upf.edu
Received June 30, 2011; revised August 3, 2011; accepted August 16, 2011
Abstract
Secondary loan sales give originating banks the opportunity to diversify part of their credit risk by selling
loans to other market participants. However, as originating banks are less exposed to risk after secondary
loan sales, their incentives to monitor borrowers diminish. Secondary loan sales therefore involve a trade-off
between diversification benefits and sub-optimal monitoring. We explore this trade-off within a theoretical
model. The results show that in equilibrium loans trade at a discount because monitoring effort is sub-opti-
mally low. We illustrate how this inefficiency is related to lack of transparency in the secondary loan market,
and provide policy implications to address this problem.
Keywords: Secondary Loan Sales, Syndication, Monitoring, Incentives, Transparency
1. Introduction
The literature on financial intermediation (Diamond [1,2],
Ramakrishnan and Thakor [3], Fama [4], Boyd and Pre-
scott [5]) shows that asymmetric information may induce
borrowers to misreport their quality to lenders at loan
origination and, after receiving loans, to expropriate weal-
th from lenders. Financial intermediaries, and comercial
banks in particular, can overcome these problems due to
their ability to screen borrowers ex-ante (adverse selec-
tion), monitor them at interim (moral hazard), and verify
outcomes expost (costly state verification) (Leland and
Pyle [6], Allen [7], Kashyap, Rajan and Stein [8], Dia-
mond and Rajan [9,10], Coleman, Esho and Sharpe [11],
Lee and Sharpe [12]).
This literature also suggests that banks must be given
incentives to perform these expensive monitoring activi-
ties. Incentives are maximized when banks retain full
ownership of the loans that they originate. However,
during the last two decades, the increased popularity of
loan syndication, secondary loan sales and securitization
has led to a growing separation between loan originators
and loan investors. Loan originators, often commercial
banks, arrange loans by forming a syndicate of investors,
each of which purchases a portion of the loan. After syn-
dication, some of these loans are traded in active second-
dary markets (Drucker and Puri [13]). The process of
syndication and subsequent loan trading has the effect of
reducing the exposure of originating banks to the risks of
the loans, thus reducing their incentives to monitor. 1
The empirical literature has offered support to the idea
that loan sales carry a negative premium: for instance
Dahiya, Puri and Saunders [15] find that firms are nega-
tively affected by loan sales on the secondary loan mar-
ket, and that the long-term performance of firms whose
loans are sold is significantly poorer than that of match-
ing firms. Along the same lines, Berndt and Gupta [16]
report a 9% per year under-performance of borrowers
whose loans are sold in the secondary market over the
three-year period following the initial loan sale. Drucker
and Puri [13] provide evidence that loans sold in the
secondary market carry more restrictive covenants, pre-
cisely to alleviate the drop in a bank’s monitoring effort.
If loan sales reduce the value of the borrower by in-
creasing agency costs, why do we observe a widespread
use of them? One possible explanation is that retaining
loans on the balance sheet is costly for originating banks.
Pennacchi [17] and Gorton and Pennacchi [18] suggest
that intermediaries sell loans when the cost of internal
financing is sufficiently high, possibly due to capital re-
quirements. Han, Park and Pennacchi [19] show that loan
1Keys, Mukherjee, Seru and Vig [14] show that this mechanism applies
also to the market of sub-prime mortgages, whereby achieving full
insurance via securitization reduces the issuer’s incentives to monitor
the mortgages. securitization is another way for banks to increase lever-
P. COLLA ET AL.
82
age beyond standard capital restrictions imposed by the
regulator. In this way, securitizing banks can benefit
from larger tax shields.
The novelty of this paper is that we provide a formal-
ization of loan sales as a risk sharing device. Our basic
premise is the observation that banks are concerned
about the credit risk in their loan portfolio: most banks
do indeed engage in active risk management programs to
control their exposure to risk. The recent financial crisis
reinvigorated the debate on the adoption of new rules for
the global banking system, which clearly certifies the
concern that both regulators and practitioners share in
keeping banks’ risk exposure under control. Keeping this
concern into account, we show that banks resort to loan
sales as they have an interest in reducing the risk of their
loan portfolio. Our argument therefore provides a ration-
ale for the findings in Pavel and Phillis [20]: they iden-
tify risk (proxied by the degree of diversification of a
bank portfolio) as one primary factor affecting loan sales
by commercial banks.
In order to endogenize a bank’s concern with risk
management, we assume that the bank is risk-averse.
Froot and Stein [21] provide the theoretical justification
for our assumption: banks face increasing costs to raising
external funds due to information and/or agency prob-
lems and, as a results, they behave in a risk averse fash-
ion. In our model, a risk-averse bank owns a risky loan,
the future returns of which depend on the monitoring
effort of the bank (moral hazard). A risk-neutral market
exists for the loan (the syndication market). The bank’s
risk aversion leads to the sale of contractual rights over
the loan to the market. In equilibrium, the market pur-
chases a fraction of the loan which is strictly smaller than
one. The rationale of this outcome is that by exposing the
bank to some risk, incentives are preserved.
In the model, the syndication process reflects the
standard practice of underwritten deals, in which the
leading commercial or investment bank guarantees the
entire commitment and then syndicates the loan (Miller
[22]). Often the arranger willingly retains a share of the
loan (Dennis and Mullineaux [23]); in other cases, it
does so unwillingly because it cannot fully subscribe the
loan, and is then forced to absorb the difference.
Typically, the arranging bank tries to sell part of the
loan at a later time (the secondary market). Consequently,
we incorporate in our model the possibility of a second
sale taking place after syndication. Suppose that this sale
occurs, and that the residual part of the loan is purchased
by market participants that were not part of the initial
syndicate. Suppose further that the initial syndicate par-
ticipants do not know whether the second sale occurs or
not. This is a realistic assumption, considering that many
syndicated loans are not traded in public markets. In
other words, we assume here that the syndication market
and the secondary market are segmented. Then, due to
risk aversion the bank will want to sell the rest of the
loan in the secondary market and thus obtain complete
insurance.
At what price will the secondary market buy the loan?
The value of the loan in the secondary market will be
lower than in the syndication market, as a suboptimal
level of monitoring is priced in. If the syndication market
did not anticipate the secondary sale, syndicate partici-
pants would overpay for the asset. Instead, as the second-
dary sale is anticipated by the syndication market in
equilibrium, the loan trades in the syndication market at
a lower price. This finding provides an explanation for
the negative price reaction that Dahiya, Puri and Saun-
ders [15] document upon the announcement of a loan
sale.
How can efficiency be restored in the syndication
market? First, borrowers and syndicate arrangers can
employ contractual provisions that restrict loan resalabil-
ity. Consistent with this prediction Pyles and Mullineax
[24] find that in the syndicated loan market, two types of
constraints on loan resalability are common: 1) prior
consent constraints implemented by the borrower or the
syndicate’s lead arranger and 2) a minimum denomina-
tion requirement for loan resales. Second, transparency
in the secondary market can be increased, for example by
requiring loans to be publicly traded. Third, regulators
can introduce upper limits on loan resales. Unfortunately,
each of these measures comes at a cost: 1) contractual
restrictions on resalability imply lower liquidity which
translates in higher spreads and larger collateral (Pyles
and Mullineax [24], Drucker and Puri [13]); 2) opening
up of the loan market to the public can be perceived
negatively among issuers, lenders, and regulators as pri-
vate information migrates into public hands with the risk
of breaching confidentiality agreements between lenders
and issuers (Miller [22]); 3) the consequences of setting
the wrong limit to the maximum amount of loan resale
may completely offset the benefits of such policy.
The rest of the paper is structured as follows: in Sec-
tion 2 we introduce the framework of our model which
resembles the fixed investment model of Holmstrom and
Tirole [25]. In Section 2.1 we examine the optimal sale
of loans during syndication and show that an incomplete
sale of the loan occurs in equilibrium. In Section 2.2, we
consider the effect of a secondary market and how this
leads to the sale of any residual share by the originating
bank. In Sections 2.3 and 2.4 we show that the secondary
sale is strictly inefficient because it reduces the value of
the loan in the syndication market, which prices the loan
accordingly, as if no monitoring occurred. Finally, Sec-
tion 3 provides a discussion of our results and draws
Copyright © 2011 SciRes. TEL
83
P. COLLA ET AL.
some policy implications.
2. The Model
Consider a setting in which a bank issues a loan L that
generates returns

0,RR
e0
. The bank’s monitoring
effort over the loan is and the cost of effort is
,1
 
e0,.
Define
1
πPr| eRR 1and
πPr |RR
0 .
e
π
0 Monitoring affects the returns of
the loan with probability as follows:
e
10
ππΔππ 
0
, (1)
where 10 and 1
π,π,Δπ 0π1
Once the bank has
issued the loan, it may choose to sell (part of) it to other
market participants (hereafter referred to as “the syndica-
tion market”). We refer to such sale as loan syndication.
Indicate with α and A respectively the percentage of the
loan that is syndicated and the price at which it is sold to
the market. The timing of contracting is as follows: the
bank issues the loan (t); it then syndicates (possibly part)
of it (t1); it chooses whether to monitor the loan (t2); fi-
nally, returns are cashed in (t2).
We make the following assumptions:
A.1. (Bank): the bank’s preferences are quasi-linear in
effort, , and the utility func-
tion displays risk-aversion, i.e.
 
,e e
L
ux ux

u
0u
and
. Effort e is unobservable (and therefore un-
contractible) and the reservation utility of the bank
is nil, .
0u
(0) 0u
A.2. (Syndication market): the syndication market is risk
neutral and has all the bargaining power.
Following assumptions 1 and 2, the bank’s expected
utility is
 



e
e
,,e π1
1πe,
L
UA uARL
uA L


 
A
(2)
while that of the syndication market is

e
,,e π
M
UA R

. (3)
As the latter utility function shows, the expected cash
flows of the syndication market are proportional to the
share of the loan that is syndicated.
Moreover, we impose the following assumptions on
the model parameters:
A.3. The loan has positive NPV irrespective of effort:
10
ππ0RL RL
 ; (4)
A.4. Both the loan return and cost are sufficiently large
with respect to the cost of effort:

0
11
0
1ππ
ππ
Ruu R









10
π
π
Lu
 

, (6)
where 1
u
denotes the inverse of the bank’s utility func-
tion.
2.1. Equilibrium Characterization
The financial contract
,
A
is chosen to maximize the
syndication market’s expected utility. Since we are in-
terested in contracts where the bank acquires the loan
and monitors it, we include the following conditions in
the syndication market’s program:

,,1 ,,0
LL
UAUA

(IC)
,,1 0
L
UA
(PC)
which describe respectively the incentive compatibility
(IC) and participation (PC) constraints of the bank. The
optimal financial contract

,
A

is then obtained by
solving the following program:
**
1
,
,argmaxπ
A
A
RA

(7)
subject to

π10uAR LuA L


 

(8)

11
π11πuAR LuA L

  (9)
and 01
, , where we use (2) to explicitly
write IC and PC, and the last two conditions correspond
to the feasibility constraints. The solution to program
(7-9) is given in the following:
0A
Proposition 1. The optimal financial contract is given
by:
**1
0
π
1 and π
RRALu
 

, (10)
which implies that full syndication (sale) never occurs,
i.e. *1
.
Proof. For notational convenience, we define
((1)uuA RL)
 and (uuAL)
as the levels
of the bank’s ex-pos t utility in both states of nature. As-
suming interior solutions for
**
,
A
, the Lagrangian
of program (7-9) is given by


1
11
,;,ππ
π1π
LARA uu
uu
 







, (11)
with associated FOCs
11
ππ π0uu



  (12)

*' *'
**
11
ππ1π1uuuu



(13)
, (5) where we set
1uAuR

L
 and
Copyright © 2011 SciRes. TEL
P. COLLA ET AL.
84
uuAL

. Solving Equation (13) for the multi-
plier μ gives


*
*
11
1π
π1π
u
u
u
u
 
 , (14)
which is always positive due concavity of uand
uu
so that PC binds. Replacing μ from Equation (14)
into Equation (12) and solving for the multiplier λ gives


**
11
*
π1π
π
u
u
u
u

(15)
According to Equation (15), λ is non-negative. In par-
ticular, 0
if and only if uu
, or equivalently
. Replacing into the IC gives 1
1
0
which cannot hold. Thus at the optimum it cannot be that
. It then follows that
1
0
, so that IC binds. As
both IC and PC bind at the optimum, we can solve them
as a system of two equations in u and u. We get

0
π
1u/π and 0
π
/π
u
, or equiva-
lently the optimal contract
,
A
0
in Equation (10).
Condition (5) ensures , while

0u0
and
yield
0u
0R so that . Finally, condition
(6) corresponds to the feasibility condition .
1
0A
Proposition 1 shows that inducing effort requires the
bank to bear some risk, i.e. . This stems from the
fact that the optimal contract
1
,
A

makes both the
bank’s participation and incentive constraint binding.
Furthermore, observe that as PC binds at the optimum,
the bank receives its reservation utility, while the market
makes a profit equal to


0
10
11 1
1ππ
ππ 1π
ππ
RL uu
1

 




, (16)
The allocation of bargaining power means that the
market fully internalizes the returns of the loan, as well
as the cost of financing it, while providing a compensa-
tion to the bank for exerting effort.
2.2. Secondary Sale
Suppose now that after syndicating
at t1 and before
exerting effort at t2, the bank sells to a second market
whole or part of the residual shares that it still holds (S
)
in exchange for cash (S
A
). We refer to the contract
(,
SS
A
) as the secondary sale. Following Gorton and
Pennacchi [18], “these are contracts under which a bank
sells a proportional (equity) claim to all or part of the
cash flow from an individual loan to a third party buyer.
The contract transfers no rights or obligations between
the bank and the borrower, so the third party buyer has
no legal relationship with the bank’s borrower. Further-
more, loan sales involve no type of recourse, credit en-
hancement, insurance, or guarantee because only then
can the originating bank remove the loan from its bal-
ance sheet (according to regulatory accounting rules).”2
From the previous section, we know that if the share
held by the bank falls below
, condition IC is vio-
lated. Therefore, a secondary sale necessarily induces a
drop in effort. The secondary market then prices the sale
with e0
and solves the following program:
**
0
,
,argmaxπ
SS
SSS S
A
A
RA

(17)
subject to


**
0
*
0
π1
1π0
SS
S
uAAR L
uAAL

 
   (18)
and *
01,
SS
A

0
 
*
1
, where the first condition
describes the interim PC of the bank, while the last two
conditions correspond to the feasibility constraints. A
solution to this program requires that the interim PC
binds at the optimum, so that the bank is once again left
at its reservation utility. Furthermore, given that: 1) the
loan has positive NPV if , due to assumption A.3.
and 2) the bank is risk averse, due to assumption A.1.,
then complete sale is required at the optimum, i.e.
S
e0
e0
. Complete sale implies a violation of the
bank’s IC, which instead requires the bank to bear some
risk. It then follows that a secondary sale induces a drop
in effort, i.e.
. We summarize these results in the
following:
Proposition 2. The optimal secondary sale provides
full insurance to the bank:
1and
SS
A
LA


 (19)
Proof. Similarly to the proof of Proposition 1, we de-
fine

1
SS S
uuAA RL


 (20)
and
SS
uuAAL
 (21)
as the levels of the bank’s ex-post utility in both states of
nature after the secondary sale took place. Assuming
interior solutions for*
, the Lagrangian writes

000
,; ππ1S
SSS SS
LAu
A
Ru
  

 

, (22)
with associated FOCs
1
S
u
0
, (23)

00
π1π1
SS
uu

, (24)
where now

1
SS
uuAARL


 (25)
2See also Gorton and Haubrich [26] on this point.
Copyright © 2011 SciRes. TEL
85
P. COLLA ET AL.
and
S
uuAAL


. From condition (23) we have

10
S
u
, so that the interim PC binds. Adding up
the two FOCs gives


0
1π0
SS
uu
, (26)
which implies SS
uu
since 0
. Condition SS
uu
is equivalent to full syndication so that the interim PC
reduces to , thus yielding
S
uAA L

0
*
S
A
LA .
2.3. Insurance and Inefficiency
A secondary sale is profitable for the bank: while the syn-
dication market compensates it for exerting effort, in
equilibrium and the bank saves
e0
. In this sense,
the bank profits from “fooling” the syndication market.
Moreover, lower effort means lower expected returns on
the loan. The bank is unaffected, because the secondary
sale offers it perfect insurance. On the contrary, the ex-
pected utility of the syndication market drops. More
formally, when , the return to the syndication
market is
e0



0
1
1
0
10
1
1π
π
π
,,0π
π
1π
π
M
u
UA RL
u






 


(27)
and the loss in expected utility equals . As wealth
in the syndication market drops by more than what the
bank gains, we conclude that:
πR
Corollary Due to assumption A.3.,π0R
, the
reduction in effort associated with a secondary sale is
strictly inefficient.
2.4. Restoring Efficiency
The inefficiency of a secondary sale rests on the premise
that syndicate participants do not anticipate that a secon-
dary sale will occur. However, in equilibrium the syndic-
cate market does anticipate the effects of a secondary
sale on effort. This means that the syndicate market dis-
regards the IC of the bank and (7) rewrites as

0
,
,argmaxπ
A
A
RA

 (28)
subject to



00
π11π0uAR LuA L
   (29)
and 01,0
A
, where
,
A
denotes the optimal
contract when the syndicate participants correctly foresee
that a secondary sale will occur. Solving the maximize-
tion we find that
1
and
A
L.3 This shows that
complete syndication now takes place.
3. Discussion and Conclusions
We have shown that the existence of a secondary market
leads to complete syndication of the loan and to an inef-
ficient reduction of effort. Therefore, in equilibrium there
is too much syndication and too little effort. The sub-
optimality of these choices leads to inefficient loan pric-
ing (too low) during syndication. As discussed above,
this result is consistent with the finding of Dahiya, Puri
and Saunders [15] that the announcement of a loan sale
produces a negative price reaction for the selling firm.
This inefficiency arises because the bank is unable to
commit that it will not undertake a sale after syndication.
Can efficiency be restored via some commitment mecha-
nism? This question has important practical scope and
policy implications. Consider the following three mecha-
nisms:
3.1. Contractual Provisions
In the syndicated loan market, borrowers and syndicate
arrangers sometimes employ contractual restrictions that
influence a loan’s liquidity. More precisely, Pyles and
Mullineax [24] show that the syndicated loans often limit
resales by loan owners. The constraints can require prior
consent for resale by the borrower and/or arranging bank
or establish a minimum amount for secondary market
sales. However, there is a drawback to the introduction
of these constraints: limiting the owner’s capacity to sell
reduces the loan’s liquidity. Liquidity is a valued char-
acteristic of debt contracts, so there is some cost to con-
straining loan sales. The authors find that the direct costs
are reflected in higher fees or rates on constrained loans,
while the indirect costs are captured in stricter loan con-
tract terms on collateral or covenant protection.
3.2. Transparency
If a second sale is observable, first-market participants
will require the bank to pay them a fine Δπ
F
R if it
engages in a second sale. 4
By doing so, the bank will
refrain from selling its residual share to the second mar-
ket, thus restoring efficiency. From a policy perspective,
this advocates in favor of an increase in market trans-
parency. One way to increase transparency is to require
loans to be publicly traded. During the last two decades,
important steps have been made in this direction. The
3The proof of this result easily follows from the proof of Proposition 2
j
ust replacing the interim PC with the time t0 participation constraint.
4Notice that F
is not sufficient here to prevent renegotiation.
Copyright © 2011 SciRes. TEL
P. COLLA ET AL.
86
line between public and private in the loan market has
become less clear recently, due to the explosive growth
of non-bank investors groups that operate on the public
side of the market, including a growing number of mu-
tual funds, hedge funds, and even CLO boutiques; and
also because of the growth of the credit default swaps
market (Miller [22]). However, almost paradoxically, the
opening up of the loan market to the public has been
perceived negatively among issuers, lenders, and regula-
tors as this migration of once private information into
public hands might breach confidentiality agreements
between lenders and issuers.
3.3. Regulation
Suppose there is a regulator whose aim is to maximize
welfare so that effort is induced in equilibrium. To do so
the regulator may forbid the bank from engaging in a
second sale. However, this may prove difficult if the
second market is not under the control of the regulator,
because for example it is in a foreign country. This sug-
gests that market integration or a “global” regulator may
achieve efficiency. An alternative strategy is for the
regulator to allow syndication up to a certain limit, i.e.
in our model. Clearly, this rule is difficult to imple-
ment because such limit varies across loans—the invest-
ment and return profile in our model, L and R—as well
as across bank types—the cost of effort,
. The cones-
quences of setting the wrong limit are twofold, depend-
ing on whether the threshold is set too high or too low.
Suppose the rule states that the maximum level of syndi-
cation is equal to the level
. If a loan requires a
, then the bank syndicates
in the first market
and
in the second market, thus exceeding the
incentive compatible share
. As a consequence, effort
drops to zero and incomplete syndication occurs -a com-
bination that is clearly undesirable. On the other hand, if
a loan has
, the bank is asked to syndicate less
than it would like to. Both cases suggest that a policy of
one-size-fits-all may generate inefficiencies that are dif-
ficult to quantify.
To sum up, we envisage three different mechanisms
that can reduce the inefficiency arising from secondary
loan sales. Restrictions on loan resalability can be im-
posed either by syndicate members via the inclusion of
contractual provisions, or by the regulator. Alternatively,
efficiency can be restored by increasing the transparency
of the secondary loan market. Each of these measures
comes at a cost. Contractual provisions that limit loan
resalability may result in higher spreads and more strin-
gent collateral requirements. An upper limit on loan re-
salability imposed by the regulator may generate ineffi-
ciencies when banks differ in their attitude towards risk
and/or monitoring skills. Finally, opening up the loan
market to the public may breach confidentiality agree-
ments between lenders and issuers.
4. Acknowledgements
We thank George Pennacchi for useful comments. All re-
maining errors are ours.
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