ON THE OPTIMAL DESIGN OF RISK RETENTION IN SECURITISATION

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Abstract

This paper examines the optimal design of retention in securitisation, in order to maximize welfare of screening per unit of retention, assuming that screening is costly and that the bank intends to securitise its loans. In contrast to the focus of previous literature on tranche retention, we deviate from the constitutional mechanisms of tranche retention to present a pareto-optimal method of tranche retention. Unlike the current ad-hoc-regulations, we derive the optimal design of retention from a utility maximization problem. We show that the level of retention per tranche should be dependent on the rate of credit default, i.e. the higher the rate of default, the higher the optimal rate of retention required to provide an incentive to screen carefully. From this approach, it follows that the rate of retention per tranche should be higher, the higher the position within the ranking order of subordination. Accordingly, the efficiency of tranche retention can be enhanced, reducing the level of retention required to maintain a given level of screening-effort. This retention design entails a recovery of the bank’s equity capital, thereby increasing liquidity and lending capacities.

Keywords: Securitization, Screening Incentives, Retention Requirements, Moral Hazard

How to cite this paper: Kaptan, M. (2011). On the optimal design of risk retention in securitisation. Risk Governance and Control: Financial Markets & Institutions, 1(3), 50-57. https://doi.org/10.22495/rgcv1i3art5