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Market Discipline and Securitization? Frederic Malherbe? September 8, 2010 Abstract In this paper, I ask whether securitization really contributes to better risk- sharing. To do this, I first formalize the concept of market discipline with a key ingredient: the ability for market participants to observe information that is non- verifiable. Then, I compare securitization with other mechanisms that differ on the timing of risk-transfer. I find that for securitization to be an efficient risk-sharing mechanism, it requires market discipline to be strong and adverse selection not to be severe. This seems to seriously restrict the set of assets that should be securi- tized for risk-sharing motive. Additionally, I show how ex-ante leverage may mitigate interim adverse se- lection in securitization markets and therefore enhance ex-post risk-sharing. This is interesting because high leverage is usually associated with “excessive” risk- taking. 1 Introduction Securitization has been widely blamed for the 2007-2009 financial crisis. Still, it is commonly believed that it is a powerful mechanism to spread and share risk in the economy. In this paper, I challenge such conventional wisdom and show that securi- tization is an efficient risk-sharing mechanism under strong conditions only. It might therefore apply to a very restricted class of assets. ?This is the second chapter of my PhD Dissertation at ECARES, Universite libré de Bruxelles. I am grateful to Mathias Dewatripont, Georg Kirchsteiger, Thomas Laubach, Patrick Legros, Jaume Ventura, and especially to Philippe Weil for their insightful comments. This paper is part of a broader research project that was started while I was visiting the MIT. I thank Emmanuel Farhi, Bengt Holmstr?m, Pablo Kurlat, and the MIT theory group for fruitful discussions during the early phases of the project, and the Department of Economics for its hospitality. All errors remain mine. ?London Business School, fmalherbe@ 1 Securitization consists of