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Working Paper Series no. 377: Bank monitoring incentives and optimal ABS

Abstract

The paper examines a continuous-time delegated monitoring problem between a competitive investor and an impatient bank monitoring a pool of long-term loans subject to Markovian "contagion." Moral hazard induces a foreclosure bias unless the bank is compensated with the right incentive-compatible contract. Fees are paid when the bank's performance is on target and liquidation arises when the bank's performance is sufficiently poor. I show that the optimal contract can be implemented with a whole loan sale involving both credit risk retention based on ABS credit default swaps and credit enhancement in the form of a reserve account. The optimal securitization bears out rulemaking recently proposed in the wake of the Dodd-Frank Act on a number of controversial provisions. I argue that further efficiency gains could be reaped by extending the role of the "premium capture" account into a liquidity buffer capturing performance-based compensation as a way to increase skin in the game over the life of the deal.

Henri Pagès
April 2012

Classification JEL : G21, G28, G32

Keywords : ABS Credit Default Swaps, Banking Regulation, Default Correlation, Dynamic Moral Hazard, Optimal Securitization, Risk Retention.

Mots-clés : ABCDS, aléa moral dynamique, corrélation des défauts, réglementation bancaire, rétention du risque, titrisation optimale

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Working Paper Series no. 377: Bank monitoring incentives and optimal ABS
  • Published on 04/01/2012
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Updated on: 06/12/2018 11:09