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

A securitization sponsor is required to retain 5% of the credit risk of each securitized pool, a so-called skin-in-the-game rule. Which risk is this rule primarily designed to mitigate?

A risk retention rule mainly mitigates moral hazard. By forcing the sponsor to keep part of the credit risk, it ensures the sponsor suffers losses if underwriting is poor, aligning its incentives with investors who lack the originator's information about borrower quality.

  1. AInterest rate risk arising from prepayments
  2. BMoral hazard arising from the originator's information advantage and reduced incentive to monitorCorrect
  3. CLiquidity risk arising from market-wide funding stress
  4. DCurrency risk arising from cross-border investors

Explanation

Risk retention aligns the originator's interests with investors by leaving it exposed to losses, countering moral hazard and adverse selection in what it sells. It does not address prepayment, funding liquidity or FX risk.

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