Credit Risk Management Practice Exam

In the originate-to-distribute model, which statement is true about risk management?

1. The lender retains all credit risk throughout the loan

2. The risk is always transferred to the borrower

3. The lender assesses risk-reward pricing before seeking funding

4. All credit risk is managed solely by the SEC

The correct answer is: The lender assesses risk-reward pricing before seeking funding

In the originate-to-distribute model, risk management is crucial for lenders as they evaluate the potential return relative to the risks involved before they seek funding. This approach requires lenders to analyze the creditworthiness of borrowers thoroughly, determining an appropriate interest rate that reflects the risk associated with the loan. By doing so, lenders can manage their exposure to credit risk effectively, ensuring that the pricing of loans is aligned with the level of risk they are taking on. This process of risk-reward pricing means that lenders are not merely passing off the risk to others; they are actively involved in assessing and pricing the risk before they package loans for sale or securitization. This assessment helps them make informed decisions on whether to fund the loan or seek additional funding, factoring in both market conditions and the individual borrower's profile. The other statements do not accurately reflect the mechanics of the originate-to-distribute model, where the lender indeed engages in assessing risk before funding rather than merely transferring risk to another party or retaining all credit risk. The role of external regulatory bodies like the SEC is also misrepresented, as they do not manage all credit risk; rather, they oversee compliance within the financial services industry.