Securitization and the dark side of diversification |
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| Affiliation: | 1. University of Chicago Booth School of Business, United States;2. Kellogg School of Management, Northwestern University, United States;1. PUC-Rio, Department of Economics, Brazil;2. PUC-Rio, Department of Economics, Itaú BBA, Brazil;1. Department of Economics and Finance, University of Guelph, 50 Stone Road East, Guelph, Ontario N1G 2W1, Canada;2. Department of Economics, Queen’s University, 94 University Avenue, Kingston, Ontario K7L 3N6, Canada;1. Research Department, Financial Stability Wing, Norges Bank (Central Bank of Norway), Bankplassen 2, P.O. Box 1179 Sentrum, 0107 Oslo, Norway;2. Market Infrastructure Division, Financial Stability, Bank of England, Threadneedle Street, London EC2R 8AH, United Kingdom |
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| Abstract: | Diversification by banks affects the systemic risk of the sector. Importantly, Wagner (2010) shows that linear diversification increases systemic risk. We consider the case of securitization, whereby loan portfolios are sliced into tranches with different seniority levels. We show that tranching offers nonlinear diversification strategies, which can reduce the failure risk of individual institutions beyond the minimum level attainable by linear diversification without increasing systemic risk. |
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| Keywords: | Securitization Diversification Systemic risk Risk management Tranching |
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