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Bank incentives and optimal CDOs

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Author Info
Pagès, H.

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Abstract

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.

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Publisher Info
Paper provided by Banque de France in its series Documents de Travail with number 253.

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Length: 41 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:bfr:banfra:253

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Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
Web page: http://www.banque-france.fr/
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Related research
Keywords: Credit risk transfer; Default Risk; Contagion.;

Find related papers by JEL classification:
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February. [Downloadable!] (restricted)
    Other versions:
  2. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  3. Bruno Biais & Thomas Mariotti & Guillaume Plantin & Jean-Charles Rochet, 2007. "Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications," Review of Economic Studies, Blackwell Publishing, vol. 74(2), pages 345-390, 04. [Downloadable!] (restricted)
    Other versions:
  4. Peter M. DeMarzo & Michael J. Fishman, 2007. "Agency and Optimal Investment Dynamics," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 20(1), pages 151-188, January. [Downloadable!] (restricted)
  5. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 18(1), pages 1-35. [Downloadable!] (restricted)
  6. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters, in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc. [Downloadable!]
    Other versions:
  7. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October. [Downloadable!] (restricted)
  8. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April. [Downloadable!] (restricted)
    Other versions:
  9. Chiesa, Gabriella, 2008. "Optimal credit risk transfer, monitored finance, and banks," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 464-477, October. [Downloadable!] (restricted)
  10. PETER M. DeMARZO & YULIY SANNIKOV, 2006. "Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model," Journal of Finance, American Finance Association, vol. 61(6), pages 2681-2724, December. [Downloadable!] (restricted)
  11. Adam B. Ashcraft & Til Schuermann, 2008. "Understanding the securitization of subprime mortgage credit," Staff Reports 318, Federal Reserve Bank of New York. [Downloadable!]
  12. Peter M. DeMarzo & Michael J. Fishman, 2007. "Optimal Long-Term Financial Contracting," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 20(6), pages 2079-2128, November. [Downloadable!] (restricted)
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