Capital Recycling and Moral Hazard in the Securitization Market

Abstract

Securitization allows the recycling of scarce bank capital but exacerbates the moral hazard problem inherent in banks' private choices of loan monitoring. In a model combining these aspects of the securitization market, I show that an appropriately-designed proportional retention requirement, if implementable, may improve social welfare. I then consider if rating agencies may mitigate the moral hazard problem of banks. I illustrate that rating inflation may occur with perfectly rational investors, and that mandating credit rating may further exacerbate rating inaccuracy. Therefore, even given market imperfections, governments may optimally leave rating agencies unregulated.

Keywords: securitization, bank regulation, credit rating agencies

JEL Classification: G24, G18