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Department of Business and Management Science, Norwegian School of Economics (NHH) Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)

No 2011/7:
A Shot at Regulating Securitization

John Kiff () and Michael Kisser ()

Abstract: In order to incentivize stronger issuer due diligence effort, European and U.S. authorities are amending securitization-related regulations to force issuers to retain an economic interest in the securitization products they issue. The idea is that if loan originators and securitizers have more skin in the game they will more diligently screen the loans they originate and securitize. This paper uses a simple model to explore the economics of equity and mezzanine tranche retention in the context of systemic risk, accounting frictions and reduced form informational asymmetries. It shows that screening levels are highest when the loan originating bank retains the equity tranche. However, most of the time a profit maximizing bank would favor retention of the less risky mezzanine tranche, thereby implying a suboptimal screening effort from a regulator's point of view. This is mainly due to lower capital charges, loan screening costs and lower retention levels. This distortion gets even more pronounced in case the economic outlook is positive or profitability is high, thereby making the case for dynamic and countercyclical credit risk retention requirements. Finally, the paper also illustrates the importance of loan screening costs for the retention decision and thereby shows that an unanimous imposition of equity tranche retention might run the risk of shutting down securitization markets.

Keywords: Securitization-related regulations; the economics of equity; (follow links to similar papers)

JEL-Codes: G00; (follow links to similar papers)

36 pages, April 6, 2011

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