Working Paper: CEPR ID: DP8403
Authors: Gilles Chemla; Christopher Hennessy
Abstract: We examine screening incentives, welfare and the case for mandatory skin-in-the-game. Ex ante banks can screen, using interim private information to choose retentions and structuring. Ex post speculators trade with rational hedging investors. Absent regulation, there is a separating equilibrium with voluntary retentions. If funding value is high, banks may instead originate-to-distribute (OTD), selling the entire asset in opaque form, deterring informed speculation and destroying screening incentives. Under weaker conditions, banks instead sell the asset in transparent form, using tranching to increase hedging demand, informed speculation and price informativeness. With sufficient informed speculation, transparent OTD actually creates stronger screening incentives than voluntary retentions. In all unregulated market equilibria, interim adverse selection reduces screening incentives, so mandated retentions potentially increase welfare. To induce screening via pooling, banks should be required to retain a uniform junior tranche size which decreases in informational efficiency. However, uniform retention mandates may not be optimal. To improve risk-sharing, screening can instead be induced via separating contracts by compelling banks to choose from a menu of junior tranche retention sizes. In either case, efficiency of risk-sharing is maximized by splitting marketed claims into safe senior and risky mezzanine tranches. Finally, the separating (pooling) regulatory regime generally leads to higher welfare if efficient risk-sharing (bank investment scale) is the dominant consideration, and is always optimal in informationally inefficient markets.
Keywords: Adverse Selection; Originate to Distribute; Screening Incentives; Securitization; Skin in the Game; Speculator; Uninformed Investors
JEL Codes: D82; G21; G32; G38; L51
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| mandatory retention requirements (G32) | screening incentives (M52) |
| absence of mandatory retention (G33) | pooling equilibrium (D51) |
| pooling equilibrium (D51) | underinvestment in screening efforts (I14) |
| mandatory retention (M51) | payoff spread between high and low types (C46) |
| payoff spread between high and low types (C46) | effort in screening (C93) |
| different retention structures (G32) | varying effects on risk-sharing and welfare (D69) |