Detrimental Effects of Retention Regulation – Incentives of Loan Screening in Securitization Under Asymmetric Information

We consider an economy where a lender finances his loans to borrowers by issuing a securitized product to investors and where the credit quality of the product may depend on whether the lender screens the borrowers. In the presence of asymmetric information between the lender and the investors about the credit quality of potential borrowers that the lender faces, overvaluation (from the lender’s viewpoint) of the low quality securitized product may occur, which reduces the lender’s incentive to conduct costly screening of the borrowers and hence leads to issuance of the securitized product of low credit quality. This is likely to occur when the probability is low that the average credit-quality of potential borrowers is low. Hence, in the OTD business model, the low quality product tends to be issued just after the economic boom hits the peak, or when some of the lending opportunities start deteriorating, but not in the recession where majority of the lending opportunities are already bad. In this situation, we investigate the efficacy of retention regulation that requires the lender to hold a minimum ratio of his own securitized products, and find that such regulation is not necessarily effective to solve this incentive problem. Even worse, in a certain situation, the retention regulation discourages the lender's screening effort and reduces welfare.