Securitization: Better Discipline Than Bank Run?
Campos, Rolf; Islas, Gonzalo
Original document: Times of Broken Promises: Financial Fragility vs. Securitization
Financial securitization has attracted a lot of negative press, much of it well deserved, given the pivotal role securitization markets played in the 2007-08 financial crisis.
Securitization involves the pooling and repackaging of cash-flow producing financial assets into "securities" that are then sold on to investors.
The main benefit to banks is that it allows them, as loan originators or issuers, to lock in profits from long-term investments, as well as remove assets from their balance sheets, in order to comply with the established capital reserve ratios.
According to the Securities Industry and Financial Markets Association (SIFMA), the stock of outstanding mortgage-backed securities in the United States exploded from $5.93 trillion in 2004 to $9.14 trillion in 2007, in the run-up to the collapse.
In their paper, "Times of Broken Promises," IESE Prof. Rolf Campos and Gonzalo Islas debunk popular theories on the role of securitization. They offer an alternative rationale that does not rely on risk sharing.
They also suggest that securitization may yet play a crucial role in global finance as a disciplinary mechanism.
S.O.S: Scrutiny of Securitization
Once the financial crisis erupted in 2007-08, doubts began to surface about the rigor with which financial institutions had assessed the quality of the assets underlying securitized instruments. As a result, serious doubt was cast over securitization's credit-enhancing functions.
However, according to the authors, the roots of the problem had less to do with the securitization model per se, and more to do with the sustained period of low interest rates leading up to 2007.
Low interest rates tend to mean lower per loan margins for financial intermediaries. To make up for this loss, many banks increased the number of loans they offered customers. However, since the increase in loans was limited by capital ratios, there was an incentive to take them off the banks' balance sheets through securitization.
Fragile Structures as Disciplinary Mechanisms
How can market discipline be achieved in the financial sector?
Academics such as Calomiris and Kahn (1991) and Diamond and Rajan (2001) have considered environments in which, due to environmental and contracting constraints, the payment promised to a lender can still be affected by an action of the borrower.
Put simply, if the borrower cannot commit to behave, there is a moral hazard.
Good behavior can only be enforced if there is a way of punishing the lender.
Therefore, what those academics have argued was that the financial fragility inherent in the banking system -- via the threat of a run on the bank -- acts as a disciplinary mechanism.
Security in Securitization?
Campos and Islas identify a number of weaknesses in such models of financial fragility, one of which is their inherent dependence on a static environment.
Such models are, in essence, one-shot games. According to the authors, this is unrealistic, as players do not play the game only once.
They propose that repeated games would be a much better way of thinking about a world in which financial intermediaries interact frequently.
The authors take these models of moral-hazard environments and repeat them infinitely, implying the need for repeated financing.
They also incorporate ideas of imperfect public monitoring, meaning that you can't always observe what the other player is doing. This is a more realistic scenario than one that assumes perfect public monitoring, as most current theories do.
What they conclude from their own model is that, with this repeated access to markets, intertemporal incentives arise, which are sufficient to remove the cost of moral hazard in the static environments outlined by Calomiris and Kahn, and by Diamond and Rajan.
Put simply, the need to go to the market repeatedly allows market participants to punish the bank by shunning their assets should it misbehave.
To illustrate the problem, the authors cite the example of a restaurant in a tourist destination that does not expect repeat visitors. As such, the restaurant has little incentive to deliver high-quality service, since diners are unlikely to come back. Thus, its best strategy would be to lower costs by lowering service.
Now suppose that many tourists decide to move to the tourist town permanently. Diners are more likely to come back because they live nearby.
The restaurant will naturally start to pay much greater attention to service quality, because it now expects more frequent interaction with its clientele. In essence, its intertemporal incentives have changed.
The authors claim that, by restoring intertemporal incentives as punishment for misbehavior, securitization could be more effective than the use of financial fragility as a disciplining device.
When there is no tomorrow, punishment can only be delivered today. In the Calomiris and Kahn model, this effectively means destroying the bank via a bank run.
However, if there is the possibility of future interactions -- that is, a repeated game scenario -- there are more alternatives for punishing.
Regulators or clients can, therefore, choose a punishment that is not as destructive, such as shunning assets in a market, rather than bankrupting the bank.
Furthermore, moving away from the one-shot game, toward a model based on the use of repeated games with imperfect public monitoring, could help to strip away some of the unrealistic assumptions upon which many conventional financial theories are based.