You are here

Working Paper Series no. 253: Bank incentives and optimal CDOs


The paper examines a delegated monitoring problem between investors and a bank holding a portfolio of correlated loans displaying “contagion.” Moral hazard prevents the bank from monitoring continuously unless it is compensated with the right incentive-compatible contract. The asset pool is liquidated when losses exceed a state-contingent cut-off rule. The bank bears a relatively high share of the risk initially, as it should have high-powered incentives to monitor, but its long term financial stake tapers off as losses unfold. Liquidity regulation based on securitization can replicate the optimal contract. The sponsor provides an internal credit enhancement out of the proceeds of the sale and extends protection in the form of weighted tranches of collateralized debt obligations. In compensation the trust pays servicing and rent-preserving fees if a long enough period elapses with no losses occurring. Rather than being detrimental, well-designed securitization seems an effective means of implementing the second best.

Henri Pagès
September 2009

Classification JEL : G21, G28, G32.

Keywords : Credit risk transfer, Default Risk, Contagion.

Download the PDF version of this document

Working Paper Series no. 253: Bank incentives and optimal CDOs
  • Published on 09/01/2009
  • EN
  • PDF (367.24 KB)
Download (EN)

Updated on: 06/12/2018 11:00