[PEN-L:34243] Global Financial System: BIS report on Credit Risk Transfer

[Sabri Oncu <soncu@xxxxxxxxxxx>]

Theoreticians may like to think in the abstract but, given my
experience in dealing with data, this is the real issue:

> *Aggregate data - the relative dearth of information
> at the level of the individual firm is paralleled by
> an incomplete picture of how CRT markets are developing
> in aggregate. Central banks and others are currently
> exploring how to improve their database related to CRT
> instruments without imposing an undue reporting burden
> on market practitioners.

More generally, the real issue is data, aggregate or not. It is
not just that data are noisy, or as I always say, full of junk,
but, forgetting about the issues of aggregation, ask this: How
good a measure the width of the shoulders is of the height, or
the weight, of a person?

Best,

Sabri

+++++++++++++

January 31:  Credit Risk Transfer
Location: New York
Author: RiskCenter Staff
Date: Friday, January 31, 2003


The Bank for International Settlement (BIS) this week came out
with a report by a Working Group that was established by the
Committee on the Global Financial System.

The following is an executive summary of the report and to view
the full report click on www.riskcenter.com and go to the Global
Reports box.

Executive Summary

Techniques for transferring credit risk, such as financial
guarantees and credit insurance, have been a long-standing
feature of financial markets. In the past few years, however, the
range of credit risk transfer (CRT) instruments and the
circumstances in which they are used have widened considerably.

A number of factors have contributed to this growth, including:
greater focus by banks and other financial institutions on risk
management; a more rigorous approach to risk/return judgments by
lenders and investors and an increasing tendency on the part of
banks to look at their credit risk exposures on a portfolio-wide
basis; efforts by market intermediaries to generate fee income; a
generally low interest rate environment, which has encouraged
firms to search for yield pickup through broadening the range of
instruments they are prepared to hold; and arbitrage
opportunities arising from different regulatory capital
requirements applied to different kinds of financial firm. The
significance of CRT seems to vary appreciably across firms and
market segments. Thus, for example, the intermediation of credit
default swaps seems to be a major business line for a small, but
only a small, number of firms; and CRT markets are particularly
active for major company credits, much less so for SMEs. Given
these differences, it may be misleading to talk about the overall
impact of CRT. However, while CRT flows have been substantial,
and despite recent growth, CRT activity seems still to be
relatively small compared with the outstanding stocks, and even
the current flows, of credit-riskrelated instruments.

After setting out some of the broader background (Section II),
this Report reviews the recent development of CRT markets,
describing the characteristics of the instruments used, the
nature of the market participants and the reasons for their
involvement (Section III). It then discusses some of the
principal features of the markets themselves, focusing on the
questions of transparency and data availability, on how CRT
instruments of different kinds are priced and on how far the
existence of CRT markets has affected the process of price
discovery (Section IV).

The remainder of the Report (Sections V, VI and VII) identifies
and analyses some possible implications of the evolution of CRT
markets for the overall functioning of the financial system and
discusses some of the concerns which have been expressed about
the impact of CRT on financial stability.

CRT instruments typically change the relationship between
borrowers and lenders and establish new relationships between
lenders and those to whom they may pass on credit risk (Section
V). This implies in particular changes in the incentives which
the different parties to a credit transaction face. The Report
analyses these changes in terms of potential market failures, for
example asymmetric information, principal/agent problems and
incomplete contracts. It concludes that most of these problems
have been recognised by market participants and market
authorities and have been addressed in one way or another. In
some cases, however, it has proved difficult or impossible to
arrive at an entirely satisfactory solution. One common approach
is to ensure that the risk shedder retains some interest in the
performance of the borrower and therefore some incentive to
monitor the borrower?s performance carefully. Such retention can,
however, diminish the attraction of CRT transactions in so far as
regulators may not recognise the risk transfer for capital
requirement purposes unless it is complete. A further problem has
proved to be the formulation of contracts in a way which is
unambiguous in all plausible circumstances. In a number of cases
a situation has arisen which was not anticipated at the time a
contract was drawn up and in which the interests of the parties
to the contract have diverged. At one level this is a
legal/documentation issue, and some worthwhile progress has been
made, in this and in other areas, by developing the standard ISDA
contract. Further improvements could no doubt be introduced. Some
especially difficult issues arise, however, in relation to the
definition of "restructurings" and their inclusion as credit
events. At present it is not clear how far these are capable of
being resolved by legal drafting and how far they reflect deeper
problems of contract design. In any case, there remains a concern
that those who believe they have shed risk could sometimes find
that they have not, and that those who believe they are not at
risk may find that they are.

The Report considers (in Section VI) some structural implications
of the wider use of CRT. In particular, it notes that rating
agencies play a central role in some CRT markets. To an extent
this is no different from the role which they already play in the
rating of corporate debt (and indeed the market in single name
credit derivatives is, broadly speaking, confined to names which
are already rated). But the rating agencies arguably have an even
more important role in relation to portfolio instruments, and
their models have set market standards for credit risk assessment
of such instruments. While the analytical basis for these
assessments has been advancing, there are still some significant
unresolved questions, notably about the way diversification
effects should be handled. This in turn implies some uncertainty
about the pricing of the instruments themselves. CRT also has a
potentially major impact on the way that banks go about their
business. Increasingly, they are acting as credit originators
rather than long-term funders, shifting loans off their balance
sheet either individually or as part of a package through loan
transfers and securitisation. In some cases, however, they
continue to act in an agency capacity in terms of monitoring and
servicing the loans. While these trends now seem firmly
established, they have so far had only a relatively small impact
on the profile of business for the banking sector as a whole,
with a possible exception in the area of credit card receivables
and mortgages in some countries.

Innovation in financial markets, and within that the development
of new financial instruments such as credit derivatives, is
generally to be welcomed as increasing market efficiency,
enabling better diversification of portfolios and providing a
wider range of techniques for risk management. However, there are
a number of aspects of CRT which raise policy issues and which,
at least in some cases, might point to the need for a policy
response (Section VII). Some of the main ones are as follows:

*Transparency - financial firms? disclosure of their CRT
activities is patchy at best. In a fast developing market with a
potentially significant effect on the distribution of risks this
lack of disclosure is a concern. The Report suggests that the
issue might best be addressed by lending support to existing
initiatives on disclosure (eg Fisher II) and by flagging the
specific concerns in relation to CRT.

*Aggregate data - the relative dearth of information at the level
of the individual firm is paralleled by an incomplete picture of
how CRT markets are developing in aggregate. Central banks and
others are currently exploring how to improve their database
related to CRT instruments without imposing an undue reporting
burden on market practitioners.

*Rating agencies - the Report notes the critical role of rating
agencies in various CRT markets and the implicit reliance on the
risk assessment techniques which they use. Although the Report
does not formulate any view on the desirability or otherwise of
this state of affairs, the CRT dimension should be taken into
account in the various reviews of the rating agencies? activities
which are at present in progress.

*Diversification and concentration - one of the principal
potential benefits of CRT is that it facilitates the wider
dispersion of risk and allows risk profiles to be adjusted more
flexibly. At the same time, some elements of the CRT market
appear to be highly concentrated, which might give rise to market
disruption if the firms concerned were to come under pressure.

*Contract design - as previously noted, the formulation of
restructuring clauses in credit derivatives contracts has proved
to be particularly problematic. It remains to be seen whether the
difficulties can be resolved; if not, it could act as a
significant brake on the further development of this part of the
CRT market.

*Risk management - although in many respects CRT involves
familiar risk management issues, it does sharpen questions about
counterparty risk in relation to unfunded risk transfers, given
the speed and scale of possible changes in exposures, and also
raises technical questions about the reliability of pricing of
portfolio instruments. In addition, there are a number of issues
related to documentation on which further work is needed. More
fundamentally, there has been concern that CRT could lead to a
weakening in overall credit risk monitoring if those who end up
holding the credit risk have less information about the borrower
than the original lender. Market practice has, however, evolved
in a number of ways to mitigate this risk.

*Accounting - divergences in accounting rules have had a
restraining effect on certain parts of the CRT market. As credit
risk (at least vis-a-vis larger borrowers) becomes more readily
tradable, it may also increase the tension between book value and
mark to market valuation. Although the Report did not explore
this (contentious) issue it is clear that it is attracting
increasing attention from practitioners.

*Regulation - CRT has the potential to highlight more clearly
differences in the regulatory treatment of credit risk as between
different kinds of institution and is, therefore, likely to work
towards a more integrated approach to regulatory capital
standards. The International Association of Insurance Supervisors
and the UK Financial Services Authority have recently reviewed
the regulatory implications of CRT.

http://www.riskcenter.com/cgi-bin/article.pl?id=6151