The much higher default rates on cohorts of US sub-prime loans originated in 2006 and 2007 compared with earlier years is indicative of the consequences of this lack of incentive (see  BIS Review 101/2009  7  Fig. 10). The originator needs to have enough “skin in the game” if he is going to exercise due diligence in loan origination – and having a reputation at stake may not always suffice. Second, the crisis revealed that many of the risks that securitisation was supposed to distribute more widely had in fact remained either within the banking system, or else could be re-intermediated back into it. Thus, the debt securities issued by one bank were not sold on to investors outside the banking system, but were instead bought by the proprietary trading desks of other banks, leading to a network of cross-holdings of the underlying loans. That may make sense when the main risks are idiosyncratic to the loans originated by particular banks, but looks rather foolish when the risks are macroeconomic in nature and the returns on all such securities are correlated. Moreover, a considerable amount of the remaining risk was contained in institutions which, while not formally recognised as banks, engaged in exactly the same sort of maturity transformation, financing long-term assets by short-term debt instruments. These included entities such as conduits, which housed the securitised loans and then financed them by selling short-term paper.
But in many cases these entities had back-up credit lines to the supporting bank, so that when funding difficulties arose, the securitised loans in effect came back onto the bank’s balance sheet. And even where there was no formal obligation to act as a lender of last resort, originators often chose to provide back-up finance in order to protect their name in funding markets. The motive for setting up these off-balance-sheet entities was entirely one of regulatory arbitrage. Off-balance-sheet vehicles were not required to hold capital in the same way as a bank would if the loans were on their balance sheet. So it appeared to be a neat way to boost profits without having to raise more capital. The Banco d’España, the Spanish banking supervisor, insisted that Spanish banks would have to treat conduits and the like as on balance sheet for capital purposes. As a result, Spain did not see the mushrooming of these off-balance-sheet vehicles. A third distortion lies in the nature of remuneration contracts. Incentive contracts that offer potentially unlimited upside rewards, but cap the downside losses, encourage traders to take on excessive risk. One unintended consequence of financial innovation was that it enabled clever traders to create positions with considerable embedded leverage – that is, portfolios requiring little payment up front, but whose returns amplified changes in the value of the underlying assets. Traders then had a natural incentive to gravitate towards these types of highly risky instruments.