SECURITIZATION, MARKET RATINGS AND SCREENING INCENTIVES *

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1 SECURITIZATION, MARKET RATINGS AND SCREENING INCENTIVES * Thomas P. Gehrig University of Freiburg and CEPR, London Paper Proposal for the BSI Gamma Foundation Conference on: The credit crisis: causes, effects, and lessons in Zurich September 2 nd, May 24 th, 2008 Very preliminary please do not quote Abstract: The paper compares screening incentives for the originate-and-distribute business model of banking with the traditional originate-and-hold strategy. While in the traditional banking model banks act as delegated monitors (Diamond, 1984), in the market-based model with securitized loans rating agencies provide market information about otherwise non-transparent securities. Since rating agencies concentrate on producing information on the lower tail of the return distributions of securitized loan portfolios, however, less societal information is produced under the originate-anddistribute business model. This finding implies that liquidity assistance by central banks should discriminate across business models in order to provide better information production incentives. These results are compounded, when rating agencies also offer financial advice to the originating banks. On a more fundamental level we provide a model to analyze the (strategic) interaction between credit risk and liquidity risk in the banking industry. * Helpful comments by Philipp Hartmann, Hans-Helmut Kotz, Giovanna Nicodano and Marco Wölfle are gratefully acknowledged. - Correspondence: Thomas Gehrig: University of Freiburg, D Freiburg, Germany, thomas.gehrig@vwl.uni.freiburg.de.

2 Research Questions: The securitization of mortgage loans of subprime quality is widely regarded as one culprit for the transmission of the recent international banking crises. Based on a large scale empirical study for the US Mian and Sufi (2008) even argue that moral hazard on behalf of originators is the main culprit for the US mortgage default crisis. By selling off loans, they imply, screening incentives may have been impaired and sub-quality assets were sold to international investors. While it is clearly true that securitization helped banks to change their business models from originate-and-hold towards a strategy of originate-and-sell, it seems less clear, why international market participants did not react to those changes. If there was moral-hazard, why did investors not anticipate it properly and require increased risk premia to account for the higher risk of the underlying securities? In fact, the literature on securitization maintains that optimal securitization does in fact add liquidity without impairing screening incentives. 1 Typically, according to theory originating banks should keep the highest loss tier in their own books (e.g. see De Marzo, Duffie, 1999 or Francke, Krahnen, 2005 for pre-crisis evidence in Germany). The current experience, however, seems to suggest that banks were successful in selling-off those highest loss tiers apparently at rather subsidized prices. Obviously, prior to the crisis originating banks could profit from the inability of market participants to properly price the complex bundles of securitized loans. Since by the very nature of the lending process originating banks enjoy an informational advantage, final investors will typically have to rely on the services of other information producing intermediaries such as rating agencies. But what are the screening incentives for rating agencies? Will they produce the same information as originating intermediaries? How will their information production contribute to the performance of the market for securitized loans? Which implications can be derived for public policy, financial regulation, and/or monetary policy? How should liquidity assistance be optimally designed? 1 In this regard Bhattacharya and Chiesa (2008) even argue that monitoring incentives can be optimized by means of optimal credit risk transfers. 2

3 These questions can be enriched by considering different market environments, such as competitive versus concentrated markets for ratings and by analyzing closely related markets such as rating and consulting. How does bundling of rating and consulting services affect information production? Research Strategy: Addressing these issues we take the view that the advent of large scale securitization and the change in banking business models may have completely changed the informational environment making it difficult for market participants to assess the underlying risks correctly. Rating agencies, by their very nature are more concerned about the lower tails of the return distribution of a given security, while an originating investor typically produces information about the full distribution of returns. In this regard, the originating investor can profit from high return chances in a better and more flexible way than an investor relying only on estimates of default probabilities of the underlying security. This basic hypothesis will guide the analysis throughout the paper. This project is the first to model and analyze the differential information acquisition incentives between banks, rating agencies, and their interaction. Step i) In the projected paper we start out and characterize the screening incentives of rating agencies in a very simple market environment, based on the modeling framework of Gehrig (1998), Gehrig (2005) and Hauswald and Marquez (2007). We analyze the screening incentives of rating agencies and the incentives for originating banks and compare the implications for bank liquidity across both business models. Preliminary analysis verifies that information acquisition incentives and consequently also the allocation of credit are quite different across the two different business models of banking, i.e. for the traditional originate-and-hold and the modern originate-and-distribute model. Under the latter model, overall less credit is available for high risk investments such as venture capital investments. On the other hand, the aggregate default probabilities should be lower under securitization. This is particular true the more opaque the underlying securities are. Presumably, in reality and not in 3

4 our model - the complexity of securities considerably adds to their effective opaqueness. We may extend our analysis by adding a behavioral section in order to discuss the clearly highly relevant complexity issues in a meaningful way, but this extension would constitute a side aspect of our contribution. Step ii) One immediate implication of our findings is that liquidity assistance should discriminate lending terms according to the business model used by banking institutions. Nondiscriminatory terms will in fact subsidize the originate-and-sell business model, which overall generates less information than the traditional originate-and-keep model of banking. 2 From a societal perspective the originate-and-distribute model does not seem superior in the baseline model. On a more general level, however, this study will allow us to analyze the interaction between liquidity risk and credit risk. As the changing business models in the banking industry clearly demonstrate, the process of securitization can profoundly affect banks liquidity management. At the same time securitization affects credit risk and the allocation of credit in an economy. Hence on the basis of our baseline model we expect deeper insights into the fundamental strategic relation between credit risk and liquidity risk in banking. Our model can speak to the issue of how liquidity risk can substitute for credit risk and vice versa. This aspect constitutes a major and as we think fundamental innovation in the scholarly literature, which so far has concentrated on the analysis of each risk factor in isolation and basically ignoring the close interactions between the two. 3 2 The UK experience with Northern Rock exemplifies the potential costs of subsidizing the originate-anddistribute business model. In fact, Northern Rock almost entirely relied on money markets to fund the origination of mortgages. 3 To the best of our knowledge only view papers like Francois and Morellec (2004) and Ericson and Renault (2006) address the relation between these two fundamental categories of banking risk. While credit risk and liquidity risk have been major focus of scholarly interest in their own right, the joint interactions between those risk factors have been largely ignored or modeled in a rather ad-hoc way like the two papers mentioned above. 4

5 Step iii) In a third step we enrich the analysis by allowing rating agencies to advice banks about their securitization policy. Essentially this means that rating agencies can sell some of their information and, thus, recover parts of their investment costs. Allowing information sales by rating agencies provides better incentives for information production. Moreover, it allows rating agencies to also benefit from information about the higher return sectors of the return distribution. Hence, information sales enhance screening incentives of information producers in the market. The drawback, however, stems from reduced investment incentives of the originating banks themselves. Step iv) It also seems highly relevant to address the role of the intensity of competition in the rating industry on information incentives. Larger rents would generally seem to stimulate information production. However, as Gehrig (1998, 2004) and Gehrig, Jackson (1998) in a related securities model demonstrate such a claim would decisively depend on the properties of the underlying pool of projects as well as the properties of the screening technology. While regime classifications are readily available, simple general rules typically are not. Step v) The paper concludes with a section on the robust empirical predictions of the baseline model and its various extensions. Thus proper empirical work of testing the underlying hypotheses will be encouraged. While this paper concentrates on laying a theoretical basis, it prepares the ground for future empirical work. 5

6 Summary Overall we propose a simple model to analyze information production in banking markets. 4 Information is produced by originators and specialized information intermediaries (rating agencies). The process of securitization adds to liquidity while at the same time affecting incentives to information production of the originating banks. This framework allows us to analyze the strategic interaction between credit and liquidity risk. References Bhattacharya, S. and G. Chiesa, 2008: Optimal Credit Risk Transfer, Monitored Finance, and Investment Incentives, mimeo. Broecker, T., 1990: Credit-Worthiness Tests and Interbank Competition, Econometrica 58, De Marzo,P. and D. Duffie, 1999: A Liquidity-Based Model of Security Design, Econometrica 67:1, Diamond, D., 1984: Financial Intermediation and Delegated Monitoring, Review of Economic Studies, 51, Ericsson J. and O. Renault, 2006: Liquidity and Credit Risk, Journal of Finance, 61(8), Fisher, I., 1933: The Debt-Deflation Theory of Great Depressions, Econometrica 1, Foucault, T. and T. Gehrig, 2008: Stock Price Informativeness, Cross-Listings, and Investment Decisions (mit Thierry Foucault), Journal of Financial Economics 88, 2008, In contrast to capital markets banking markets would seem to be characterized by a larger degree of opaquenss, less information availability about the underlying risks and less liquidity in the trading process. For a recent example about the role of market structure on information production in capital markets see Foucault and Gehrig (2008). 6

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