Does Regulatory Capital Arbitrage or Asymmetric Information Drive Securitization?

Abstract

Banks face the choice of keeping loans on their balance sheet as private debt or transforming them into public debt via asset securitization. Securitization transfers credit and interest rate risk, increases liquidity, augments fee income, and improves capital ratios. Yet many lenders still choose to retain a portion of their loans in portfolio. An open research question is whether lenders exploit asymmetric information to sell riskier loans into the public markets or retain riskier loans in response to regulatory capital incentives (regulatory capital arbitrage). We examine this question empirically using micro-level data and find that securitized mortgage loans have experienced lower ex-post defaults than those retained in portfolio, providing evidence consistent with the latter explanation for securitization.

Keywords: Banks, debt, securitization, regulatory capital