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Securitization and the dark side of diversification

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  • Maarten van Oordt

Abstract

Diversification by banks affects the systemic risk of the sector. Importantly, Wagner (2010) shows that linear diversification increases systemic risk. We consider the case of securitization, whereby loan portfolios are sliced into tranches with different seniority levels. We show that tranching offers nonlinear diversification strategies, which can reduce the failure risk of individual institutions beyond the minimum level attainable by linear diversification, without increasing systemic risk.

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File URL: http://www.dnb.nl/en/binaries/working%20Paper%20341_tcm47-270451.pdf
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Bibliographic Info

Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 341.

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Date of creation: Mar 2012
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Handle: RePEc:dnb:dnbwpp:341

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Web page: http://www.dnb.nl/en/
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Related research

Keywords: Securitization; Diversification; Systemic risk; Risk management; Tranching;

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  1. Acharya, Viral V., 2009. "A theory of systemic risk and design of prudential bank regulation," Journal of Financial Stability, Elsevier, vol. 5(3), pages 224-255, September.
  2. Slijkerman, Jan Frederik & Schoenmaker, Dirk & de Vries, Casper G., 2013. "Systemic risk and diversification across European banks and insurers," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 773-785.
  3. Acharya, Viral V & Yorulmazer, Tanju, 2004. "Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies," CEPR Discussion Papers 4778, C.E.P.R. Discussion Papers.
  4. Allen, Franklin & Babus, Ana & Carletti, Elena, 2013. "Asset Commonality, Debt Maturity and Systemic Risk," Working Papers 10-30, University of Pennsylvania, Wharton School, Weiss Center.
  5. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  6. C.G. de vries, 2004. "The simple economics of bank fragility," WO Research Memoranda (discontinued) 755, Netherlands Central Bank, Research Department.
  7. Wagner, W.B., 2006. "Diversification at Financial Institutions and Systemic Crises," Discussion Paper 2006-71, Tilburg University, Center for Economic Research.
  8. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 1-35.
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