The Financial Stability Oversight Board (FSOB) has released their analysis and broad recommendations for how to balance the costs and benefits of risk retention associated with securitization (here). The issue I have blogged about before (here) is that we want banks to hold the risk of the loans they make so they have the incentive to lend wisely (see securitization and the recent subprime lending crisis)s; on the other hand, we want them no to hold this risk because if an economywide disturbance like a decline in national house prices leads to these loans all losing money, then the banking system can collapse (see the Great Depression). The reason many underestimated the impact of the subprime crisis was that we thought securitization had removed many real-estate based loans from bank balance sheets. In fact, they were off-balance sheet, but they were real liabilities for large investment banks.
So how to balance the desire to insure banks and the desire to incentivize them? The FSOB discusses many issues but I think misses the boat. There is a simple way to do both. Have banks hold all (or a lot of) the risk that their loans perform worse than average and have them sell off all (or a lot of) the risk of the average loan (both statements about loans in some class of loans). There are many ways to do this. One is to have the banks securitize little, but make them hedge their macro risk using an index of the performance of similar loans. Another is to have them securitize and sell everything in bundles of many banks’ loans, but take the proceeds from the sale, place them in a common trust (that invests in say Treasuries), and pays out to each bank in proportion to how well its loans do relative to the rest of the banks loans. In either case, each bank is incentivized to make good loans – if it does not, it makes less money – and yet holds no systemic risk that can take down the banking sector – if house prices for example tumble, either the hedges on the index pay off or the total sum of payments to banks from the trust is unchanged.
This seems so important, and so simple (at least in theory).