Bankruptcy Remoteness and Incentive‐compatible Securitization

• DOI: http://doi.org/10.1111/fmii.12029
• Author: Gabriella Chiesa
• Date: 01 May 2015
• Published date: 01 May 2015

Bankruptcy Remoteness and Incentive-compatible

Securitization

BYGABRIELLA CHIESA

Securitization involves both the risk allocation and claims’ transferability/liquidity.A key

ingredient of liquidity/claim-transferability is bankruptcy remoteness of the securitized

assets. Weanalyze the implications of the bankruptcy-remoteness created by securitization

on risk allocation and bank monitoring incentives,in relation to the bank’s liability structure;

and the regulatory/policy issues it gives rise to. We demonstrate that (1) the need for

regulation arises when securitization (and bankruptcy remoteness) coexists with deposit-

taking; and (2) regulation that imposes the same capital requirements on a bank irrespective

of whether loans are securitized or not will have welfare implications. Wealso explain the

need for narrow-securitized banking.

Keywords: Securitization, Bankruptcy remoteness, Risk transfer.

JEL Codes: G21, G28, K22, D86.

I. INTRODUCTION

Securitization can be viewed as performing two functions. One refers to risk

allocation: the transfer of risks from the banking sector to outside investors – deep-

pocketed investors who are better able to absorb losses would share in the risk.

The other function consists of creating transferable/liquid securities (Gorton and

Metrick, 2013; Shin, 2010). A key ingredient of liquidity/claim-transferability is

bankruptcy remoteness: the insolvency of the sponsor (the bank that has originated

the loans) has no impact on the securities. Indeed, securitization involves the

transfer of ownership of assets (e.g. loans) to a separate legal entity (a special

purpose vehicle, or SPV) which then sells claims on the assets to outside investors

in exchange for liquid funds. The transfer of ownership of the underlying assets to

a separate legal entity allows the bank (loan originator) to establish the bankruptcy

remoteness of the SPV and the transferred assets (Ayotte and Gaon, 2011).1

Bankruptcy remoteness results from Court decisions and regulatory rules that

allowed securitization and REPO special treatment under the bankruptcy code.

”Regulatory changes were an endogenous response to the demand for efficient

bankruptcy-free collateral in large financial transactions” (Gorton and Metrick,

2010).

The evidence on securitized loans’ defaults is that the bulk of the losses

(loan/mortgages defaults) were borne by the banking sector (Greenlaw et al.,

2008). Acharya et al. (2013) document that commercial banks provided insurance

to investors. Commercial banks have engaged in explicit legal commitments to

Corresponding author: Gabriella Chiesa, Department of Economics University of Bologna Piazza Scaravilli.

Email: gabriella.chiesa@unibo.it.

1Ayotte and Gaon (2011) provide evidence that the creditor protection provided by bankruptcy re-

moteness is indeed valuable and priced in financial markets.

C2015 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

242 Gabriella Chiesa

repurchase asset backed securities. For the majority of SPVs, the credit guaran-

tees were strong enough to cover all possible losses of outside investors. The

evidence thus suggests that investors (security holders) had recourse to the bank’s

balance sheet, via contractual credit guarantees, which means that risk remained

on banks, and at the same time the investors were/are protected from bank’s illiq-

uidity/insolvency,via bankruptcy remoteness. Wang and Xia (2014) examine how

securitization affects the role of banks as monitors in lending and find that banks

exert less effort on monitoring when they can securitize loans. Why do banks

exert less effort on monitoring (Wang and Xia, 2014) given that risk remains on

banks (Greenlaw et al., 2008; Acharya et al., 2013)? Could it be that not all risks

should remain on banks for the bank to monitor? And, why do banks engage in

securitization and retain (excessive) risk? What’s the role for regulation?

This paper answers these questions. It addresses and links two key issues:

1) the relation between the risk allocation and the bank’s incentives to monitor,

and the bank’s ex-ante incentives to structure its financingso as to implement the

optimal (value-maximizing) risk allocation; 2) the implications of the bankruptcy-

remoteness created by securitization on risk allocation and monitoring incentives,

in relation to the bank’s liability structure; and the regulatory/policy issues it gives

rise to.

We address these issues within a model where loan return distribution is state

contingent and bank costly monitoring is valuable in every state.2Value max-

imization requires that the monitoring agent (the bank) retains the risk it can

control via monitoring and is insulated from the exogenous risk (the realization

of state of nature). We demonstrate the effects of the risk allocation on the capital

per unit of lending that the bank needs to invest in order to find it profitable to

monitor, and hence, for a given capital base, the amount of lending that the bank

can make conditionally on finding it incentive-compatible to monitor (briefly,

bank’s incentive-compatible lending). The optimal risk allocation, where the bank

is insulated from the exogenous risk, minimizes the capital per unit of lending

that the bank needs to invest in order to find it profitable to monitor – that is, the

optimal risk allocation maximizes bank’s incentive-compatible lending. Interest-

ingly, and contrary to common wisdom, we find that there exists a left-hand-side

balance sheet financing scheme (securitization) that implements the optimal risk

allocation and thereby maximizes incentive compatible lending. The securitiza-

tion scheme that allows for that provides investors with a well defined level of

credit enhancement – that which penalizes the bank if it does not monitor. If

the bank used only left-hand-side-balance-sheet financing methods, then it would

engage in the optimal (value-maximizing) securitization scheme, since by so do-

ing it maximizes profits. By contrast, debt/deposits (balance sheet) financing is

2The relevance of banks’ monitoring role is at the centre of the financial intermediation literature;

see Campbell and Kracaw (1980), Diamond (1984), Fama (1985), Hellwig (1991), Bhattacharya and

Chiesa(1995), and Holmstrom and Tirole (1997); see also the banking literature review by Bhattacharya

and Thakor (1993). There is also ample evidence that bank monitoring improves the quality of the

firms financed (Datta, Iskandar-Datta and Patel, 1999; James, 1987; Lummer and McConnell, 1989).