Prior to the Global Financial Crisis in 2008, securitization has been widely perceived as a way to disperse credit risks, and to enhance financial system’s capacity in dealing with defaults. This paper develops a model of securitization and financial stability in the form of amplification effects. This model has illustrated three different scenarios: A negative shock in the economy will lead to downturn of the economy and falling of the asset prices, deteriorating balance sheets and tightening financing conditions. However, if there is no shock or a positive shock, banks can improve its profitability significantly through securitization. While securitization decreases the probability of systemic crisis, banks tend to suffer more when the crisis happens as a result of over-borrowing and over-investing. This paper uses a three-period theoretical model to demonstrate the impact of securitization on the financial stability, and provides clear analytical guidelines for a new regulatory framework of securitization that account for systemic risk and systemic externalities.
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