What is the Social Trade-off of Securitization? A Tale of Financial Innovation

Abstract

This paper conducts a macroeconomic welfare analysis of securitization in a real business cycle model with a banking sector. I model securitization as an optional interbank funding channel that credibly reduces the diversion ability on borrowed funds and increases operation costs on loan assets. In effect, securitization allows banks to increase the asset size while sacrificing the rate of return per unit of assets. I demonstrate that the availability of securitization increases the resilience against banking sector breakdowns and increases the size of credit booms associated with a subsequent breakdown. The economy with securitization option experiences less frequent financial recessions but once a financial recession occurs, it is likely to be more severe. In the presence of the savings glut externality where households do not internalize the effects of their savings behavior on the banking sector, the financial innovation of increasing the profitability of securitization can exacerbate an over-investment in production. Therefore, under highly developed securitization, regulation may be needed to balance the social gains and the social losses from securitization. In a calibrated version of the model, I illustrate that an optimal regulation on the incentives of securitization can make the availability of securitization socially beneficial.