Rethinking the regulatory treatment of securitization

In a model where banks play an active role in monitoring borrowers, we analyze the impact of securitization on bankers’ incentives across different macroeconomic scenarios. We show that securitization can be part of the optimal financing scheme for banks, provided banks retain an equity tranche in the sold loans to maintain proper incentives. In economic downturns however securitization should be restricted. The implementation of the optimal solvency scheme is achieved by setting appropriate capital charges through a form of capital insurance, protecting the value of bank capital in downturns, while providing additional liquidity in upturns.

► Securitization is part of an optimal financing scheme for banks since it provides contingent liquidity.
► To maintain monitoring incentives banks must retain an equity tranche in sold loans and the regulator must set appropriate capital charges.
► When macroeconomic shocks occur, securitization amplifies loan losses.
► Hence securitization should be allowed in upturns and prohibited in downturns.
► Capital requirements should be state contingent to back new lending commitments in upturns and protect for loan losses in downturns.