does regulatory capital arbitrage, reputation, or asymmetric.pdfVIP

Journal of Financial Services Research, 28:1/2/3 113–133, 2005 # 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands. Does Regulatory Capital Arbitrage, Reputation, or Asymmetric Information Drive Securitization? BRENT W. AMBROSE* University of Kentucky MICHAEL LACOUR-LITTLE** California State University, Fullerton ANTHONY B. SANDERS The Ohio State University Abstract Banks can choose to keep loans on balance sheet as private debt or transform them into public debt via asset securitization. Securitization transfers credit and interest rate risk, increases liquidity, augments fee income, and improves capital ratios. Yet many lenders still retain a portion of their loans in portfolio. Do lenders exploit asymmetric information to sell riskier loans into the public markets or retain riskier loans in portfolio? If riskier loans are indeed retained in portfolio, is this motivated by regulatory capital incentives (regulatory capital arbitrage), or a concern for reputation? We examine these questions empirically and find that securitized mortgage loans have experienced lower ex-post defaults than those retained in portfolio, providing evidence consistent with either the capital arbitrage or reputation explanation for securitization. Key words: Banks, debt, securitization, regulatory capital. Securitization is one of the major financial innovations to have occurred over recent decades (Greenspan, 1998). In securitization, heterogeneous and illiquid individual loans are combined into relatively homogeneous pools and transformed into highly liquid bonds traded in dealer markets and generically referred to as asset-backed securities. Such assets now permeate fixed income portfolios at both the institutional and individual investor level. While the largest and most well known example of securitization is the residential mortgage