A shot at regulating securitization

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.

Trustee reputation in securitization: When does it matter?

“…For instance, due to regulatory requirements, institutional investors, such as pension funds, are typically interested in holding the highest rated tranches. 13 Further evidence suggests that equity retention maximises originators' screening effort (Kiff & Kisser, 2014) and minimises information loss (Guo & Wu, 2014). However, (Kuncl, 2015) show that although retention aligns originator and investor interests, the efficiency of this device is limited especially during economic booms.…”

“…Further evidence suggests that equity retention maximises originators’ screening effort (Kiff & Kisser, ) and minimises information loss (Guo & Wu, ). However, (Kuncl, ) show that although retention aligns originator and investor interests, the efficiency of this device is limited especially during economic booms.…”

Credit Risk Transfer and Bank Insolvency Risk

“…Some of the more recent studies on information asymmetries in credit risk transfer have focused on implications for mandatory retention regulation. Kiff and Kisser (2014) suggest that without retention requirements, ineffective retention schedules may prevail if banks have incentives to economize on capital. They suggest regulators could opt to impose equity tranche retention to better align incentives.…”

Securitization and lending standards: Evidence from the European wholesale loan market

“…Recent evidence shows that a securitization instrument that retains risk may induce a more prudent risk behavior of banks than an instrument that provides only risk transferring (Carbo-Valverde et al 2015). It is also argued that equity tranche retention is an incentive for the bank to maintain monitoring incentives (Cerasi & Rochet 2014) and maximizes loan screening (Kiff & Kisser 2014). Furthermore, since 2013, the European Central Bank made mandatory for banks to provide loan level data for ABS as an eligibility requirement for its repo transactions.…”