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FRM Part I · FRM Exam Part I · Banks

Under the originate-to-distribute model, a bank makes loans and then securitizes them, selling the resulting securities to investors. Which of the following is the most significant risk-management concern associated with this model?

The main concern is weakened screening and monitoring incentives. Because the originator sells the loans and passes credit risk on to investors, it bears less of the loss from defaults, which can lead to lower underwriting standards, as seen before the 2007-2009 financial crisis.

  1. AWeaker incentives for the originator to screen borrowers carefully because credit risk is transferredCorrect
  2. BHigher interest rate risk on the originator's balance sheet because loans are held longer
  3. CReduced liquidity for the originator because assets cannot be sold
  4. DLarger required regulatory capital because all loans remain on the balance sheet

Explanation

When originators pass on credit risk, they have less incentive to monitor and screen, which contributed to deteriorating underwriting standards before the 2007-2009 crisis. The model reduces holding periods and can free capital and improve liquidity, so the other options describe the opposite effects.

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