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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank securitises a pool of loans through an SPV, retaining the equity tranche and selling the mezzanine and senior tranches. After the transfer, which statement about the bank's remaining credit risk exposure is most accurate?

The bank keeps most of the pool's credit risk, because the equity tranche it retains is first-loss and absorbs the earliest defaults. Selling mezzanine and senior tranches transfers mainly the remote, low-probability losses, not the bulk of expected loss.

  1. AIt retains most of the first-loss credit risk of the pool because the equity tranche absorbs losses firstCorrect
  2. BIt retains none of the pool's credit risk because senior tranches carry all losses
  3. CIt retains the risk only if losses exceed the senior tranche attachment point
  4. DIt retains risk proportional to the senior tranche, since equity is the safest tranche

Explanation

The equity tranche absorbs the first losses, so a bank holding it keeps the bulk of expected loss from the pool even though much notional is sold. Senior tranches lose only after subordination is exhausted. Retaining equity is why regulators and investors see it as aligning incentives.

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