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This paper shows under which conditions loan securitization, e.g. collateral debt
obligations (CDOs) of banks can increase the systemic risks in the banking sector.
We use a simple model to show how securitization can reduce the individual banks’
economic capital requirements by transferring risks to other market participants and
demonstrate that systemic risks do not decrease due to the securitization. Systemic
risks can increase and impact financial stability in two ways. First, if the risks are
transferred to unregulated market participants there is less capital in the economy to
cover these risks. And second, if the risks are transferred to other banks interbank
linkages increase and therefore augment systemic risks. We analyze the differences
of CDOs (true sale) and credit default swaps (synthetic) in contributing to these risks.
An empirical analysis finds a significant relationship between systemic risk and CDO
issuance for monthly data for the years 2000 until 2005.
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