The « originate to distribute » model [see this other post], whereby banks do not keep the loans they have originated on their balance sheets, changes the incentives of the various participants in the intermediation process, each seeking to maximize their profit (ECB, 2008).
– The institution originating the loan may have an interest in relaxing borrower selection criteria (« screening ») or reducing the costs associated with monitoring the use of borrowed funds (« monitoring »).
– Depending on their remuneration structure, intermediaries responsible for grouping loans together may favor risk-taking at the expense of expected returns, thereby creating agency costs.
– Rating agencies that are paid directly by the originator or intermediary have an incentive to give the highest possible rating to loans that have been transformed into financial products, while avoiding too rapid a downgrade in the event of default in order to preserve future income from rating or related advisory services.
– Managers responsible for collecting repayments to be distributed as dividends may have an interest in not promptly addressing problem loans in order to preserve their commissions, which are generally a percentage of assets under management.
– Investors may be discouraged from providing the discipline necessary for a complex system to function and thus be content with the risk assessment provided by rating agencies.
Thibaut D.
Reference:
European Central Bank (2008). The incentive structure of the « originate and distribute » model.
