Retention Requirements and Incentives for Controlling Inefficient Risk-Taking -- Bridging Banking, Securitization and Capital Requirements

Abstract

This paper models incentives for risk-taking by managers of banks or securitization deals. Of particular interest are risk-retention rules for producers of structured securitization deals, which have been mandated by the Dodd-Frank Act; the model can also be applied to bank managers. We show how incentives can be set up so that problems of asymmetric information can co-exist with socially optimal risk-taking. The role of holding an equity piece as an incentive tool has been over-emphasized; the best “skin in the game” incentive structure for management is to hold securities of all levels of risk, including the safest piece. As a device for protecting against bank runs, the best incentive tools require tilting the incentive structure toward the safest pieces, but not by much.

Keywords: Financial Institutions, Contingent Convertible Bonds, Management Incentives, Risk-Taking, Dodd-Frank Act

JEL Classification: G2