Crisis Talk (3)

Who holds the risk in securitization? A nice paper by Markus Brunnermeier (Princeton University) talks about how financial innovation precipitated the current crisis. A good read for anyone who is trying to understand why things unravelled as fast as they have.

The main thesis of the paper is that the financial innovation in the last decade or so, clouded the view of who holds the risks. The author says (page 9): "The main disadvantage of securitization is that the transfer of credit risk distances the borrowers from the lenders. First, it makes it unclear who holds what risk. In the end, it might very well be that the risk comes back to the issuing bank, even though it thought it had transferred the risk on to, say, a hedge fund. Second, the banks' incentive to carefully approve loan applications, and their incentive to monitor (and even to collect) these loans, is drastically reduced. Since a big part of the risk is now borne by other financial institutions, banks essentially hold the full risk only for some months before it is passed on to others. Put differently, nowadays a bank faces only a "pipeline risk." That is, only risks that are not yet passed on and are still in the bank's pipeline are the bank's concern."

The article is forthcoming in the Journal of Economic Perspectives.