Which risk management technique used to avoid credit risk has been known to lead to systemic risk?

Which risk management technique used to avoid credit risk has been known to lead to systemic risk?

• A. Diversifying the loan portfolio
• B. Hedging with interest rate swaps
• C. Selling of loans to other organizations
• D. Increasing capital reserves

Answer: (C)

Transferring credit risk by selling loans to other organizations is a way to avoid holding default risk yourself, typically through loan sales or securitization. The problem with this approach is that it creates a web of financial connections across many institutions and investors. When many loans are securitized and held by diverse buyers, losses in one asset class can cascade through the system as liquidity dries up or confidence wanes, spreading distress beyond the originating lender. This interconnected exposure is what can generate systemic risk, even though the lender’s direct credit risk is reduced. Diversifying the loan portfolio helps reduce idiosyncratic risk, hedging with interest rate swaps targets interest rate risk, and increasing capital reserves strengthens the institution’s buffer—none of these inherently create the same kind of widespread interdependence that loan sales can introduce.

Transferring credit risk by selling loans to other organizations is a way to avoid holding default risk yourself, typically through loan sales or securitization. The problem with this approach is that it creates a web of financial connections across many institutions and investors. When many loans are securitized and held by diverse buyers, losses in one asset class can cascade through the system as liquidity dries up or confidence wanes, spreading distress beyond the originating lender. This interconnected exposure is what can generate systemic risk, even though the lender’s direct credit risk is reduced.

Diversifying the loan portfolio helps reduce idiosyncratic risk, hedging with interest rate swaps targets interest rate risk, and increasing capital reserves strengthens the institution’s buffer—none of these inherently create the same kind of widespread interdependence that loan sales can introduce.