Securitization under Asymmetric Information and Risk Retention Requirement

Abstract

We address a three-period model of financial intermediaries that involves securitization of risky loan assets and asymmetric information. We show that the risk retention requirement with a fixed ratio, stipulated by the Dodd-Frank Act, might induce losses of social welfare in the sense that a bank might not utilize profitable investment opportunities due to the regulation, which leads to a downward jump in social welfare. We present various structures of social welfare with respect to the level of 'skin in the game', and clarify the necessity of countercyclical regulation by verifying that the social losses caused by current regulation become more severe during a recession. Furthermore, we verify how the financial market becomes volatile through securitization and leverage. JEL Classifications: G21, G24, G28

Financial Innovation and Fragility

“…I use the Arellano-Bond (1991) estimator by instrumental-variables (IV) estimation of the parameters of the first-difference model using lags of regressors as instruments. 23 Additionally, I use the Blundell-Bond (1998) estimator because the Arellano-Bond (1991) estimator performs poorly with large autoregressive disturbances. 24 I find qualitatively similar results.…”

Optimal Form of Retention for Securitized Loans Under Moral Hazard

“…Most criticisms focus on vertical slice retention because it is not optimal for aligning incentives of financial intermediaries to monitor borrowers (Fender and Mitchell, 2009b;Kiff and Kisser, 2010). Jeon and Nishihara (2012) also point out the weakness of the risk retention requirement in terms of other aspects of the current regulation. They highlight the impact of fixed ratios on risk retention efficiency, which is uniformly applied to every financial institution, without considering features of individual intermediary or business cycle.…”