Privately versus Publicly Optimal Skin in the Game: Optimal Mechanism and Security Design
AbstractWe examine screening incentives, welfare and the case for mandatory skin-in-the-game. Ex ante banks can screen, using interim private information to choose retentions and structuring. Ex post speculators trade with rational hedging investors. Absent regulation, there is a separating equilibrium with voluntary retentions. If funding value is high, banks may instead originate-to-distribute (OTD), selling the entire asset in opaque form, deterring informed speculation and destroying screening incentives. Under weaker conditions, banks instead sell the asset in transparent form, using tranching to increase hedging demand, informed speculation and price informativeness. With sufficient informed speculation, transparent OTD actually creates stronger screening incentives than voluntary retentions. In all unregulated market equilibria, interim adverse selection reduces screening incentives, so mandated retentions potentially increase welfare. To induce screening via pooling, banks should be required to retain a uniform junior tranche size which decreases in informational efficiency. However, uniform retention mandates may not be optimal. To improve risk-sharing, screening can instead be induced via separating contracts by compelling banks to choose from a menu of junior tranche retention sizes. In either case, efficiency of risk-sharing is maximized by splitting marketed claims into safe senior and risky mezzanine tranches. Finally, the separating (pooling) regulatory regime generally leads to higher welfare if efficient risk-sharing (bank investment scale) is the dominant consideration, and is always optimal in informationally inefficient markets.
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Date of creation: May 2011
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Find related papers by JEL classification:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
- L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
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