Adverse Selection, Licensing and the Role of Securitization in Financial Market Evolution, Structure and Pricing

This paper models the structure of a financial market that is composed of two types of institutions, banks and securities or secondary markets. The model analyzes the development of the securities market as a way of trading off its lower cost of securitization with adverse selection due to asymmetric information possessed by banks, using a simple adverse selection model in the tradition of Akerlof (1970). Successive modifications, including licensing contracts similar to those of Leland (1979) and Chan and Leland (1982) solve some of the adverse selection problems by quot;licensingquot;loan sellers in an effort to provide minimum quality standards