Loan Sales as a Response to Market-Based Capital Constraints

Models of bank loan sales often appeal to regulatory constraints to motivate this off-balance-sheet activity. Here, we present a market-based model of bank asset sales in which information asymmetries create the incentive for unregulated banks to originate and sell loans to other banks, rather than fund them with deposit liabilities. Banks have a comparative advantage in locating and screening projects within their locality. However, because of private information, banks can fund projects in their portfolio only to the extent that their capital can adequately buffer potential losses on these investments. A loan sales market allows a banker having adequate capital to acquire profitable projects originated by a banker whose own capital is insufficient to support the additional risk.