Securitization and Compensation in Financial Institutions

We analyze the interaction between financial institutions’ internal compensation policy, the quality of loans, and their securitization decision. We show when mandatory deferred bonus pay makes incentives more commensurate with the longer term risk of their transactions and hence improves the quality of loans. We also show when it has the opposite effect. We further analyze when mandatory deferred compensation can complement a policy that requires financial institutions to retain a minimum exposure to their originated loans, and we discuss the impact of a tax on short-term bonus pay. Generally, our framework allows us to study the interaction of financial institutions’ internal agency problems with the external agency problem that arises from securitization.