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Bank monitoring incentives and optimal ABS

  • Pagès, H.

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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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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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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