The Impact of Risk Retention on Moral Hazard in the Securitization Market

Abstract

Based on European RMBS deals with 24 million quarterly loan observations, we examine the effect of risk retention on bank behavior. We show that retention deals perform better due to improved monitoring effort and workout processes. We find that the probability of rating changes and collateral revaluations is higher for retention loans, and ratings are more accurate; retention loans have a lower probability of becoming non-performing, a lower delinquency amount, and a shorter time in arrears. Moreover, non-performing and defaulted retention loans are more likely to recover. Reduced losses for deals with retention are associated with lower default rates, lower exposures at default, and higher recovery rates. Our results suggest that retention reduces moral hazard and incentivizes banks to exert higher effort, which results in superior securitized asset performance.