Discussion Paper Series 2011-E-17

Detrimental Effects of Retention Regulation:Incentives for Loan Screening in Securitization under Asymmetric Information

Masazumi Hattori, Kazuhiko Ohashi

We consider an economy in which a lender finances his loans to borrowers by issuing a securitized product to investors, and where the credit quality of the product may depend on whether the lender screens the borrowers. In the presence of asymmetric information between the lender and the investors about the credit quality of potential borrowers, overvaluation of the low-quality securitized product may occur, inducing lender to not screen the borrowers and hence to issue a securitized product of low credit quality. This is likely to occur when the investors finds it difficult to distinguish the good state from the bad state, or when the seed of recession creeps toward the booming economy. A retention regulation that requires the lender to hold a minimum ratio of his own securitized products is not necessarily effective in solving this incentive problem. Even worse, in a certain situation, the retention regulation discourages the lender's screening effort and reduces welfare.

Keywords: originate-to-distribute; securitization; asymmetric information; financial regulation; screening; verification; retention

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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