We are currently experiencing a liquidity shock to the financial system, initiated by problems in the subprime mortgage market, which spread to securitization products more generally--that is, mortgage-backed securities, asset-backed securities, and asset-backed commercial paper (MBS, ABS, and ABCP). Banks are being asked to increase the amount of risk that they absorb (by moving off-balance sheet assets onto the balance sheet), but the related losses that the banks have suffered are limiting somewhat the capacity of banks to absorb those risky assets. The result is a reduction in aggregate risk capacity in the financial system as losses force those who are used to absorbing risk to have to sell off or close out their positions.
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Charles W. Calomiris is a visiting scholar at AEI.
In the June issue of Financial Services Outlook,