Risk Shifting

DEFINITION of 'Risk Shifting'

The transfer of risk to another party. Risk shifting has many connotations, the most common being the tendency of a company or financial institution facing financial distress to take on excessive risk. This high-risk behavior is generally undertaken with the objective of generating high rewards to equity owners – who face little additional downside risk but may garner significant extra return – and has the effect of shifting risk from shareholders to debt holders. Risk shifting also occurs when a company goes from offering a defined benefit plan to its employees, to a defined contribution plan. In this case, the risk associated with pensions has shifted from the company to its employees.

BREAKING DOWN 'Risk Shifting'

Risk shifting for a troubled company with significant debt occurs because, as its shareholders’ equity decreases, the stake of debt holders in the enterprise increases. Thus, if the company takes on more risk, the potential extra profits will accrue to the shareholders, while the downside risk falls to the debt holders, which means that risk has been shifted from the former to the latter.

Since management is not liable for losses incurred, financial institutions in potential or actual distress often engage in risky lending, which can negatively impact an economy by fueling asset bubbles and banking crises. In a research paper from October 2011, the International Monetary Fund cites New Century Financial – a large subprime originator – as a classic example of risk shifting. The IMF paper notes the Federal Reserve’s tightening of monetary policy in 2004 resulted in an “adverse shock” to New Century’s large portfolio of loans it was holding for investment. New Century responded to this shock by resorting to large-scale peddling of “interest only” loans, which were riskier and more sensitive to real estate prices than standard loans. This risk shifting behavior was also apparent in the business practices of other subprime mortgage loan originators, which fuelled the U.S. housing bubble in the first decade of the Millennium, the subsequent collapse of which caused the biggest global banking crisis and recession since the 1930s.

Risk management may be preferable to risk shifting by distressed companies and institutions. The risk management strategy focuses on balancing risk and return to generate cash flow that is sufficient to meet financial obligations, rather than taking the “shoot the lights out” approach of risk shifting.

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