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.

Investopedia explains '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.


Filed Under:

comments powered by Disqus
Hot Definitions
  1. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share. The investment community uses this figure to determine a company's size, as opposed to sales or total asset figures.
  2. Oil Reserves

    An estimate of the amount of crude oil located in a particular economic region. Oil reserves must have the potential of being extracted under current technological constraints. For example, if oil pools are located at unattainable depths, they would not be considered part of the nation's reserves.
  3. Joint Venture - JV

    A business arrangement in which two or more parties agree to pool their resources for the purpose of accomplishing a specific task. This task can be a new project or any other business activity. In a joint venture (JV), each of the participants is responsible for profits, losses and costs associated with it.
  4. Aggregate Risk

    The exposure of a bank, financial institution, or any type of major investor to foreign exchange contracts - both spot and forward - from a single counterparty or client. Aggregate risk in forex may also be defined as the total exposure of an entity to changes or fluctuations in currency rates.
  5. Organic Growth

    The growth rate that a company can achieve by increasing output and enhancing sales. This excludes any profits or growth acquired from takeovers, acquisitions or mergers. Takeovers, acquisitions and mergers do not bring about profits generated within the company, and are therefore not considered organic.
  6. Family Limited Partnership - FLP

    A type of partnership designed to centralize family business or investment accounts. FLPs pool together a family's assets into one single family-owned business partnership that family members own shares of. FLPs are frequently used as an estate tax minimization strategy, as shares in the FLP can be transferred between generations, at lower taxation rates than would be applied to the partnership's holdings.
Trading Center