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FRM Part II · FRM Exam Part II · Credit Risk

A bank wants to reduce regulatory capital on a loan portfolio and reduce funding needs, and sells the loans to a special purpose vehicle that issues tranched notes. The bank retains the equity tranche. Why do regulators and investors favor this retention?

Retaining the equity tranche aligns the originator's incentives with pool performance. Because the bank absorbs first losses, it has reason to underwrite and monitor carefully, reducing the moral hazard of originate-to-distribute models, though it does not make other tranches risk-free.

  1. AIt guarantees the senior tranche is risk-free
  2. BIt lets the bank avoid disclosing pool quality
  3. CIt aligns the originator's incentives with pool performance, mitigating moral hazardCorrect
  4. DIt removes the need for credit enhancement

Explanation

Originators that sell all the risk have less incentive to screen and monitor borrowers. Retaining the first-loss equity piece keeps the originator exposed to defaults, which addresses the originate-to-distribute moral hazard. It does not make senior notes risk-free or replace credit enhancement.

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