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Bank monitoring incentives and optimal ABS

  • Pagès, Henri

The paper examines a continuous-time delegated monitoring problem between competitive investors 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 of increasing skin in the game over the life of the transaction.

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Article provided by Elsevier in its journal Journal of Financial Intermediation.

Volume (Year): 22 (2013)
Issue (Month): 1 ()
Pages: 30-54

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Handle: RePEc:eee:jfinin:v:22:y:2013:i:1:p:30-54
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