Loan Sales and the Cost of Bank Capital

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Abstract
This paper demonstrates that if banks are faced with significant competition for deposit financing, as well as regulatory constraints in the form of required capital and/or reserves, banks cannot be profitable solely by holding marketable assets. They must provide other services, such as information gathering and monitoring activities related to making loans. For a bank which originates loans, loan selling will likely provide a cheaper source of funds than traditional deposit or equity finance. However, the extent to which banks can sell loans is limited by the ability of the bank--loan buyer contract to overcome a moral hazard problem. The bank’s choice of an optimal loan sales contract is analyzed with and without allowance for recourse.

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