Bougheas and Worrall model a bank's choice between selling assets individually or as portfolios. Their model can account for both the pooling and the retention strategies of banks, as long as they introduce some type of commitment on the side of banks. They demonstrate that, if the bank can commit either to a menu of contracts or to sell its whole portfolio but without committing to the size of each pool offered for sale, portfolio sales can dominate single asset sales. More importantly, they show that the portfolios that banks sell are not composed of assets of the same quality.
The authors consider a bank that wishes to sell two assets to investors. Each asset can be either high-quality or low-quality. They begin by replicating the main result in the signalling literature by showing that if the bank sells loans separately, the bank will signal the quality level of each asset by only keeping a fraction of the high quality asset on its books and will sell all low quality loans. Then, the authors consider an alternative selling strategy where the bank sells the two assets together as a portfolio. In this case, the bank's optimal signalling strategy involves retaining a higher fraction of the portfolio when both assets are high quality than when one of the assets is low quality and retaining none of the portfolio if both assets are of low quality. In comparing the two selling strategies, they find that selling separately dominates selling as a portfolio. The intuition for this result is that in the latter case there is an extra type to be separated and signalling is costly.
Next, they allow the bank to engage in more complex strategies that may involve pooling two or more portfolio types. The advantage of pooling two portfolios is that it can reduce signalling costs. However, the disadvantage is that additional incentive constraints must be satisfied. The authors identify parameter values where such a mix of pooling portfolios is optimal identifying conditions under which signalling at the portfolio level dominates signalling at the single asset level. In addition to contributing to the signalling literature this paper offers an explanation for the portfolio sales and retention strategies that banks have commonly used.
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Spiros Bougheas and Tim Worrall
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Posted on Friday 10th February 2017