Inherent Conflicts in Risk Allocation, Complexity of Financial Engineering, and Fragility of CRT Markets

There are conflicts between risk sharing and incentive provision in financial contracting under information asymmetry. Efficient risk allocation is appropriate risk sharing subject to incentive constraints. Credit risk transfer changes incentive structure of financial contracts and has dilution effect on incentive of risk seller. Contract design and reputation discipline may reduce moral hazard but cannot eliminate it. Furthermore, the complexity of structured products created through financial engineering along the risk transfer chain makes the markets very opaque, which magnifies the information problems to the extreme. The inherent fragility of CRT markets provides an important role for regulation to improve risk allocation.