Risk Sharing and Transfer

There are two motivations for securitization which possibly lead to riskier loans being sold. The first is risk-sharing or diversification, particularly of interest-rate, credit, or house-price risk. Since loans can be sold from balance sheet, banks can transfer risk from the banking system to other sectors in order to improve risk sharing with the rest of the economy (Allen and Carletti, 2006). Moreover, securitization allows banks to pool high quality loans with relative low quality ones to gain a better credit rating. For example, securities with AAA rate may be contracted by combining AAA-rated and BBB-rated securities. Therefore, securitization spurs some agencies who cannot participate in the market to have access to mortgage structured products to share risk, such as money funds and pension funds which only can invest in the assets portfolio with AAA credit rating.

Another is related to risk transfer driven by the adverse selection (Akerlof, 1970). Since lenders have more private information about credit quality of borrowers, they have incentives to sell inferior loans and retain higher-quality loans on balance sheet by using information advantages (see for example, DeMarzo and Duffie, 1999, and Parlour and Plantin, 2008). In contrast with securitization motivated by risk-

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sharing, such loans will be riskier even after controlling observable information available to investors (Elul, 2011).

It is widely acknowledged that securitization is beneficial for banks to stabilize the banking system because they do not need to bear default risk by selling loans from balance sheet to other financial institutions, at least this appeared so before the financial crisis. Many studies provide evidence of risk transfer and suggest that riskier banks have more incentive to participate in the OTD model (Gorton and Souleles, 2006; Bannier and Hänsel, 2007; Affinito and Tagliaferri, 2010).

Gorton and Souleles (2006) present a model to test the reasons for the existence of SPVs (Special Purpose Vehicles) and suggest that the main motivation for using SPVs is that they reduce bankruptcy costs. They test empirically using data for credit card ABS. Since it is very difficult to measure bankruptcy cost, they use the riskiness of the firm measured by its bond rating as a proxy. The results indicate that riskier firms are more likely to be involved in the securitization process.

Bannier and Hänsel (2007) examine whether different firm-specific variables have an influence on the decision of securitization of European CLOs. Their results show that banks with low performance are more likely to securitize, which is evidence against “appetite for risk” hypotheses in order to increase bank performance. This indicates that

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securitization is used as a tool to transfer bank risk, but risk transfer appears limited since tranches with higher credit risk seem to be retained. Drucker and Puri (2006) and Duffie (2008) argue that banks tend to retain lower quality loans and sell of high-quality loans on the condition that the return of lower-quality loans is higher than that of good quality loans and economic capital which ensures survival of banks in the worst case is much less than regulatory capital.14 Affinito and Tagliaferri (2010) control for the effect of bank regulatory capital and return and suggest that the results remain supportive of risk transfer.

In contrast, the literature believes that banks will not sell off bad loans due to reputation concerns. Ambrose et al. (2005) investigate whether lenders tend to use information advantage about borrowers to sell riskier loans to the secondary market and retain less risky loans in the portfolio by using data of a single lender between 1995 and 1997. They compare conditional default rates of securitized loans and non-securitized loans and find that securitized loans have a lower ex-post default rate relative to loans held by banks, which indicates that mortgage loans with lower default risk are more likely to be securitized under either case. Their results can support either regulatory capital arbitrage or reputation

14 _{Economic capital is determined internally based on economic conditions to}

ensure the survival of financial institutions in the event of the worst scenario whereas regulatory capital is set up externally by regulators.

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explanation.15 However, the data contain only one single lender and this does not mean that the conclusion will be true for all banks. Albertazzi et al. (2015) also examine the relationship between securitization and loan performance by using mortgages data originated by 50 Italian banks from 1995 to 2006. They suggest that securitized loans have lower default rate than non-securitized ones, which indicates that banks care about their reputation and more likely to sell good loans. Furthermore, many studies believe that bad loans are retained and securitization is not able to transfer risk to investors. As argued by Shin (2009), bad loans are retained in either the balance sheets of financial institutions or in SPVs sponsored by them, so financial institutions are still exposed to credit risk. In line with Shin (2009), Achaya et al. (2010) and Acharya and Schnabl (2013) use data from asset-backed commercial paper and provide evidence that securitization does not disperse credit risk as commercial banks suffer most losses rather than investors.