We examine the implications of optimal credit risk transfer (CRT) for bank-loan monitoring, and the incentives for banks to engage in optimal CRT. In our model, properly designed CRT instruments allow banks to insure themselves against loan losses precisely in those states that signal monitoring. We find that optimal CRT enhances loan monitoring and expands financial intermediation, in contrast to the findings of the previous literature. Optimal CRT instruments are based on loan portfolios rather than individual loans and have credit-enhancement guarantees, pretty much as banks do in practice. But the extent of credit enhancement needs to be precisely delimited. Above that exact level, monitoring incentives are undermined (loan quality deteriorates) and wealth is transferred from the bank's financiers to the bank. Properly designed risk-based capital requirements are shown to prevent such a wealth transfer and to provide banks with the incentive to engage in optimal CRT.

This paper studies moral hazard in banking due to delegated monitoring in an environment of aggregate risk and examines its implications for credit market equilibrium and regulation, in a model where banks are price competitors for loans and deposits. It provides a rationale for an incentive-based lending capacity positively linked to the bank's capital and profit margin, for an oligopolistic market structure wherever banks have market power, and for capital requirements. Social-welfare-maximizing capital requirements are lowered in recessions, are higher the more fragmented the banking sector, and are increased when anti-competitive measures are removed. In equilibrium banks earn excessive profits and credit may be rationed. Journal of Economic Literature Classification Numbers: D82, G28, L13.

This paper shows that a debt contract with warrants for the lender and cash/equity settlement options for the entrepreneur-borrower is the optimal contract in a setting with moral hazard and unverifiable states of nature. This contract makes it possible to contract optimally ex ante on unverifiable states; debt obligations are adjusted to state realizations so that debt is made safer. Moral hazard is reduced as a result.

We contrast equilibria in loan markets with bilateral bank-borrower ties, in which proprietary technological knowledge of borrowers is not revealed to product market competitors, with equilibria under multilateral financing in which such knowledge may be shared among competing borrowing firms. Using each of these two institutional arrangements, we examine the conditions for existence of equilibrium, its ex ante optimality, and borrowing firms′ incentives to engage in private costly research. Also explored is the potential for lending banks to coordinate postinvention collusion in product markets by multiple inventing firms. Journal of Economic Literature Classification Numbers: 310, 312, 314.