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Bank monitoring incentives and optimal ABS

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  • Pagès, H.

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.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 377.

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Length: 53 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:bfr:banfra:377

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

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References

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Cited by:
  1. Henri Pag\`es & Dylan Possamai, 2012. "A mathematical treatment of bank monitoring incentives," Papers 1202.2076, arXiv.org.
  2. Cerasi, Vittoria & Rochet, Jean-Charles, 2014. "Rethinking the regulatory treatment of securitization," Journal of Financial Stability, Elsevier, vol. 10(C), pages 20-31.

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