Transaction Costs, Standardization and Modularity in Credit Risk Transfer Market

Abstract

The advent of a credit risk market has profoundly altered the role of banking firms into one of asset originator and asset distributor rather than the asset holder. Banks have traditionally originated and held credit risk. It emphasis the different role of financial institutions from holders of credit risk to originators and distributors of credit risk. In this paper I aim to evaluate how the modularity and the standardization create the precondition for the creation of a credit risk transfer market in the banking industry. The intermediate market of credit risk transfer appears when the banking production processes have become more disintegrated. The vertical disintegration of the banking industry and the creation of a credit risk transfer market enables the shifting from a firm-based governance to a market-based governance. Furthermore, this paper proposes that modularity and standardization drives the creation and growth of credit risk transfer market. With the improvement of credit risk measurement methodologies and risk management practices the credit risk transfer market requires standardization and modularisation of bank lending value chain. Transaction cost economics, the dominant paradigm for understanding make or buy decisions, represents the starting point of my research. I argue that vertical integration in lending business is not only determined by transaction costs, but also by standards and modularity at product, process and industry level. I illustrate this thesis by examining how they work in mutually reinforcing ways. This perspective could open up some unexplored paths for research into economics of banking firms.