2.1.4. Performance

Apart from the factors discussed above, performance is another determinant of securitization because of the accounting benefits, intermediation profit, and higher liquidity. First, securitization allows banks to acquire accounting benefits when the book value is less than the market value of the loans, and an overvaluation of the retained interest is carried at a fair market value in the case of securitizations (Niinimaki 2012). Moreover, banks can acquire an intermediation profit via the specific design in terms of securitization loans rather than long-term warehousing (Duffie 2008). Additionally, Lockwood et al. (1996) suggest that cash inflows from securitization can be used to retire existing debt, which in turn reduces interest expenses and increases reported earnings. In spite of those potential benefits, the downsides of securitization should not be forgotten, including the fixed costs of setting up an SPV and a potential reduction in the flow of tax benefits when the assets are kept on the balance sheet and financed with debt (Calmès and Théoret 2010).

Empirical studies show the ambiguous outcomes of bank performance. Cardone-Riportella et al. (2010) presented supporting theoretical arguments indicating that more efficient and larger banks securitize their loans more frequently and may issue greater transaction volumes. On the other hand, Affinito and Tagliaferri (2010), based on a study of Italy, concluded that less capitalized and riskier banks with less liquidity are more likely to securitize their loans. Bannier and Hänsel (2008) showed that bank efficiency and size might be important determinants of securitization, while their results reveal that less profitable banks have much greater incentives to securitize their loans.

#### *2.2. Securitization and Information Asymmetries*

#### 2.2.1. Asymmetric Information in Securitization

Information asymmetry is a condition wherein one party in a relationship has more or better information than another (Bergh et al. 2018). Information about securities' intrinsic values is asymmetric, due to the long chain of structures inherent in the securitization process, resulting in a loss of information about the quality of the underlying loans (Gorton 2009). In addition, 'marketing-to-market' is not feasible in the securitization market; in such cases, valuations often involve 'marketing-to-model', which does not reflect a true market price and is associated with information asymmetry (Dowd 2009). Generally, sellers have better information about the deteriorating quality of loans than potential buyers, because most sellers (dealers) are either fully integrated or partially integrated by engaging in some process of the securitization chain; in addition, by owning an originator, sellers also have information on the quality of the originations, since the gains to acquiring better information on the quality of securities are perceived to be small, and consideration to potential buyers is not needed to value the underlying collateral in the securities. Frequently, buyers take the simpler approach of using credit agency ratings or standard copula models, which do not value the underlying securities directly (Beltran et al. 2017).

#### 2.2.2. Adverse Selection in Securitization

Information asymmetries are hard to avoid in the securitization market and will contribute to adverse selection and moral hazard problems. The adverse selection problem appears when two (or more) individuals are about to contract on a trade and one of them happens to have more information than the other(s). Seminal contributions were made

by Akerlof (1970), Spence (1978), and Rothschild and Stiglitz (1976), applying adverse selection to the product, labour, and insurance market, respectively. They stated that the information-advantaged individuals always hide key information and mislead other individuals' decisions, which could result in a threat to information-disadvantaged individuals' benefits and even drive market prices down. For example, buyers might not be able to distinguish between a high-quality car (a 'peach') and a low-quality car (a 'lemon'), while the seller knows what he/she holds. If the buyer is only willing to pay a fixed price for a car at the fair value (*p*avg), the seller will sell 'lemons' out (since *p*lemon < *p*avg) and hold 'peaches' (since *p*peach > *p*avg). Eventually, the number of 'lemon' sellers increases, and 'peach' sellers tend to leave the market, which would drive high-quality cars from the market and contribute to a market collapse (Akerlof 1970).

Banking and financial institutions are associated with adverse selection in the securitization market because of information asymmetries. According to the 'market for lemons' theory, the sellers (originators) with an information advantage will sell inferiorquality or low-quality loans to their potential buyers (investors) but retain the high-quality loans on their balance sheet via securitization. In the empirical research, the commercial mortgage-backed security (CMBS) market in the U.S. was shown to be consistent with theoretical predictions of a lemon discount; after controlling for observable determinants of loan pricing, conduit loans enjoyed a 34-basis-point pricing advantage over portfolio loans (An et al. 2011). On the contrary, some empirical evidence reflects that some financial institutions aim to build their reputation for not selling lemons to the securitization market. Lenders typically obtain soft and hard information to evaluate the credit quality of a borrower (Petersen 2004; Agarwal and Hauswald 2010). Soft information compared with hard information cannot be credibly transmitted to the market when loans are securitized. Banks securitize loans that have a relatively low amount of soft information (Drucker and Puri 2009), meaning banks retain low-default-risk loans in their portfolios. Likewise, collateralized loan obligations, as a kind of securitization, also prove that adverse selection problems in corporate loan securitizations are less severe than commonly believed (Benmelech et al. 2012). Unlike the aforementioned studies, Agarwal et al. (2012) found that the securitization strategy (adverse selection or not) of lenders changes with the financial environment; specifically, banks generally sold low-default-risk loans into the market but retained high-default-risk loans in their portfolios before the financial crisis, while most banks in financial crisis showed a pattern of adverse selection.

#### 2.2.3. Moral Hazard in Securitization

On the other hand, a situation in which information asymmetry occurs after an agreement is obtained between individuals is called a moral hazard. The term "moral hazard problem", by extension, has been applied to the principal agent problem (Stiglitz 1989). Mirrlees (1999), Holmström (1979), and Grossman and Hart (1983) have made key contributions to this area. They found that, once the contract has been signed, the agent takes advantage of hidden action and hidden information and can take more risks, because the principal bears the cost of the risks. For example, once a car insurance contract is signed, the insurance company (the principal) observes whether or not the driver is careful enough, and the driver (the agent) might not drive carefully because the insurance company bears the cost of the accident (Mirrlees 1999). A moral hazard also affects securitization market risks once the information asymmetry between lenders and securitization issuers (SPV) increases. When the lending bank sells loans, the bank no longer bears the full cost of default and thus will choose to screen the borrower less than the efficient amount; the moral hazard problem can arise if securitization issuers are naive about lender screening (Dell'Ariccia et al. 2008; Mian and Sufi 2009).

According to the empirical studies, Keys et al. (2008) found that securitization under a moral hazard leads to lax screening, which is consistent with the theoretical result. Specifically, they stated that mortgage purchasers follow a 'rule of thumb' in deciding which loans to purchase: for exogenous reasons, they are willing to buy mortgage loans given to

the borrowers with Fair Isaac Corporation scores (FICO scores) above 620. However, the default ratio of borrowers with scores higher than 620 is higher than that of borrowers with scores below 620. This is strong evidence that securitization does result in lax screening by lenders. However, Bubb and Kaufman (2014) re-examined the credit score cut-off evidence with a new dataset and through a theoretical lens that assumes rational equilibrium behaviors in comparison with moral hazards in the securitization market.

#### 2.2.4. Adverse Selection and Moral Hazard and Financial Stability

Both adverse selection and moral hazards in securitization affects financial stability and even leads to significant consequences. Adverse selection does not affect the financial market under normal economic conditions; however, as the price falls with an economic downturn, the impacts of adverse selection—an increase in uncertainty of asset value, a flight to liquidity, and a miss assessment of systemic risks (Kirabaeva 2010)—are identified by investors. Buyers (buyer panic) are afraid to invest in overpriced assets ('lemons'), which results in trading in those assets that may diminish or halt altogether. Moreover, overpriced assets lose their ability to serve as collateral for other transactions, which contributes to a credit crunch (Kirabaeva 2011). The moral hazard is the other important factor that affects financial stability. Under the 'Originate-to-Distribute' model, investors bear bank risks via buying banks' securitization, which often leads to socially excessive risk-taking (e.g., lax screening) (Dowd 2009).

#### *2.3. The Relationship between Determinants and Adverse Selection and Moral Hazard*

Based on Section 2.1, loan securitization determinants are liquidity, credit risks, regulatory capital arbitrage, and performance. Each factor reflects the different potential benefits and risks for both securitization sellers and buyers. Summarizing Section 2.2, sellers have more information about the quality of underlying loans than the potential buyers, which could result in adverse selection and moral hazards. This paper considers the adverse selection in securitization that is reflected in credit risk transfers. The bank, as the originator, knows more about the quality of underlying loans than investors. When a securitization transaction involves information asymmetry, banks transfer low-quality loans to SPV and sell them to investors with overvalued prices. With regard to moral hazards, banks that securitize their loan will generate higher profitability because investors bare those risks.

This paper aims to determine whether securitization leads to adverse selection and moral hazards through studying the determinants of securitization in the banking sector. The securitization mechanism is divided into two sections in Figure 1. Adverse selection is reflected on the right side of the figure. It mainly occurs between the originator and investors. If securitization is used as a way to transfer credit risks, a large amount of low-quality loans move into SPV and are then sold to investors. Thus, the risk exposure determinant reflects the motivation of risk transfers and is used to examine adverse selection in securitization transactions. The moral hazard is shown by whether or not banks change their behaviors and their willingness to take risks, which occurs between borrowers and banks. Liquidity, regulatory capital arbitrage, and performance can be used to examine moral hazards. These different determinants show a bank's behavioral change and change in potential risks. When securitization is used to increase bank liquidity, it might result in lax screening. If regulatory capital arbitrage drives bank securitization, banks tend to hold less capital as a cushion against asset malfunction. Improving profitability via securitization will suffer from the fixed costs of setting up an SPV and a potential reduction in the flow of tax benefits.

**Figure 1.** Framework of the study.
