A shot at regulating securitization

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. This paper contributes to the process by exploring the economics of equity and mezzanine tranche retention in the context of systemic risk, moral hazard, accounting frictions and funding distortions. It shows that loan screening activity is maximized when the loan originating bank retains the equity tranche. However, in case capital structure irrelevance does not hold a profit maximizing bank is likely to favor retention of the less risky mezzanine tranche. From a regulator's perspective this is a problem because the implied loan screening activity is substantially lower in this case. Policy attention is even more warranted if performing due diligence is costly, the economic outlook is positive or loan profitability is high.