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«WP/06/139 The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions Jorge A. Chan-Lau and Li Lian Ong © 2006 ...»

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WP/06/139

The Credit Risk Transfer Market and Stability

Implications for U.K. Financial Institutions

Jorge A. Chan-Lau and Li Lian Ong

© 2006 International Monetary Fund WP/06/139

IMF Working Paper

Monetary and Financial Systems Department

The Credit Risk Transfer Market and Stability Implications for

U.K. Financial Institutions1

Prepared by Jorge A. Chan-Lau and Li Lian Ong2

Authorized for distribution by David Marston and Mark Swinburne June 2006 Abstract This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

The increasing ability to trade credit risk in financial markets has facilitated its dispersion across the financial and other sectors. However, specific risks attached to credit risk transfer (CRT) instruments in a market with still-limited liquidity means that its rapid expansion may actually pose problems for financial sector stability in the event of a major negative shock to credit markets. This paper attempts to quantify the exposure of major U.K. financial groups to credit derivatives, by applying a vector autoregression (VAR) model to publicly available market prices. Our results indicate that use of credit derivatives does not pose a substantial threat to financial sector stability in the United Kingdom. Exposures across major financial institutions appear sufficiently diversified to limit the impact of any shock to the market, while major insurance companies are largely exposed to the “safer” senior tranches.

JEL Classification Numbers: G11, G18, G21, G22 Keywords: CDO, CDS, credit derivatives, credit risk transfer, structured credit products Author(s) E-Mail Address: jchanlau@imf.org and long@imf.org This working paper is an abridged version of Chapter V of IMF Country Report No. 06/87, March 2006.

We would like to thank Colin Miles for his extensive comments, and Piers Haben, Keiko Honjo, Ben Hunt, Nancy Jacklin, Jim Morsink, Patricia Pollard, Susan Schadler, and participants from the Bank of England, the U.K.

FSA and Treasury at a presentation held at the Bank of England, December 2005, for their helpful suggestions. All remaining mistakes are our responsibility.

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–  –  –

I. Introduction

II. Credit Risk Transfer Instruments: Structured Credit Products and Credit Derivatives........4 III. Interlinkages across Financial Institutions

IV. Exposure of U.K. Financial Institutions to Credit Derivatives

V. Regulatory and Supervisory Initiatives

VI. Conclusion

References

Table

1. Impact of Volatility in the CRT Market on Major U.K. Financial Groups, August 2003– September 2005

Figures

1. Growth of the Global Credit Derivatives Market

2. CDOs: Protection Buyers and Sellers

3. Composition of Protection Sellers (Buyers of CDOs)

4. Growth of the Global Synthetic CDOs Market

Appendices I. How Collateralized Debt Obligations (CDOs) Work

II. Key Risk Factors in Credit Risk Transfer (CRT) Markets

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–  –  –

The increasing ability to trade credit risk in financial markets has facilitated the dispersion of risk across the financial and other sectors. Credit risk transfer (CRT) instruments—such as credit derivatives and structured credit products—enable institutions to reduce their concentration of risks by passing on the “unwanted” risks. In other words, they provide a stabilization mechanism similar to that of reinsurance for the insurance sector (IAIS, 2003).

Banks, in particular, can diversify their credit risk exposure by transferring it to other banks, or more importantly, can achieve much larger diversification gains by shifting the risk outside the banking sector itself.3 Theoretically, the net outcome of CRTs should be one of benefit, with a positive impact for overall financial stability and efficiency.4 However, there are specific risks attached to CRT instruments which could be heightened, in a relatively “new” market, by the still-limited liquidity and lack of transparency in some segments. Notably, the complexity of quantitative techniques required to value and hedge these instruments is not yet completely understood, exposing market participants to potentially large losses. The situation is compounded by problems associated with, among other things, the creditworthiness of transaction counterparties, and the adequacy of existing market and legal infrastructure. Increasing interlinkages between financial institutions raise the question of whether institutions fully understand their risk exposures. For instance, while banks are shedding credit risk to insurance companies, life insurers are using capital markets and banks to hedge some of their portfolio risks (Rule, 2001). Substantial losses in credit markets experienced by German Landesbanks in 2002−03 suggest that some active participants in the market might not have the capacity to adequately manage the risks associated with CRT instruments.5 Thus, a key concern among regulators is that the rapid expansion of CRT markets may actually pose problems for financial sector stability, if a significant market event were to occur. In their increasing search for yield in recent years, a wide variety of investors—some with little experience managing credit risk—have become active sellers of protection.





Justifiably, regulators worry whether a major shock in credit markets could cause substantial and widespread losses among these investors, forcing a disorderly unwinding of credit risk positions. The general lack of accurate data on open positions in credit derivatives and structured credit instruments further increases the risks for financial stability by masking the extent of institutions’ involvement with these products. Such risks arise from the ability of investors to leverage their positions substantially compared to similar positions in cash instruments such as loans or bonds.

This paper examines the financial stability issues related to CRT markets, focusing in particular on the use of credit derivatives in the banking and insurance sectors in the United See Rule (2001) for a discussion on the motivations for credit risk transfers.

See Clementi (2001), Cousseran and Rahmouni (2005), Wagner and Marsh (2004).

See Risk (2003).

-4Kingdom.6 Within the financial sector in the United Kingdom, globally active banks such as Barclays, Hongkong and Shanghai Banking Corporation, and Royal Bank of Scotland are believed to be more exposed to CRT instruments than insurers. That said, other financial institutions have also become increasingly more active in the CRT market. Our findings suggest that diverse holdings across major financial institutions potentially active in the credit derivatives market may limit the extent of any impact from a negative shock to the market, and that insurance companies, at least the major publicly listed ones, appear to be more exposed to “safer” senior tranches.

The paper is structured as follows. Section II examines the growth of credit derivatives instruments and the proliferation of structured credit products in the global market. Section III considers the risks inherent in the CRT market, and the increasing interlinkages among financial institutions. Section IV presents the empirical evidence on the exposure of financial institutions in the United Kingdom to credit derivatives products. Issues of market regulation and supervision are covered in Section V. Section VII concludes.

II. CREDIT RISK TRANSFER INSTRUMENTS: STRUCTURED CREDIT PRODUCTS AND

CREDIT DERIVATIVES

The exponential growth of the global credit derivatives market since the instrument was first traded in 1996 has played a key role in the development of the CRT market. A credit derivative is a contract (derivative security) that is used to transfer to another party the risk that the total return on a credit asset would fall below an agreed level. This is usually achieved by transferring the risk on a credit reference asset. It does not require the transfer of the underlying asset, although the cash flow of the credit derivative instrument is determined by the credit quality of the underlying asset.7 According to the British Bankers’ Association (BBA), the value of credit derivatives products, which exceeded even the total volume of outstanding U.S. Treasury bonds at the end of 2004, is projected to surpass $8 trillion by 2006 (Figure 1).

London is the main center of the global credit derivatives market, ahead of even New York. The size of the London market is estimated to have reached $2.2 trillion in 2004, about 44 percent of the total global market of $5 trillion, compared to the New York market at 40 percent.

Examples of credit derivatives include credit default swaps (CDSs), credit-linked notes (CLNs), credit spread options (CSOs), and total return swaps (TRSs).

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8,000 7,000 6,000 5,000 4,000 3,000 2,000

–  –  –

Among the most popular structured credit products are collateralized debt obligations (CDOs).8 CDOs are constructed by “pooling” the credit risk of different financial instruments and dividing the pooled credit risk into tranches with different risk and return characteristics (Appendix I).9 CDOs generally combine three mechanisms common to all securitization

structures (Cousseran and Rahmouni, 2005):

• the construction of a reference portfolio comprising a pool of bank loans and/or negotiable financial instruments and/or credit derivatives;

• the de-linking of the credit risk of the portfolio from that of the originator of the portfolio via the use of a Special Purpose Vehicle (SPV) that issues the CDO and holds the underlying assets; and • the tranching of CDOs backed by this portfolio, with specific seniority rank in terms of rights to cash flows generated by the underlying assets.

Motivations to issue CDOs are varied. They include arbitrage opportunities (from attractive excess spreads coupled with low default rates); balance sheet management (reduced cost of funding and meeting regulatory capital requirements); providing fund managers with the opportunity to earn a stable fee income and to increase their assets under management;

providing investment banks the opportunity to earn underwriting fees and cross-sell collateral into CDOs (Memani, 2005). In other words, legal, regulatory, and economic incentives have Rule, Garratt, and Rummel (2004) define a structured credit product as “a bond combined with one or more options or forwards linked to market prices or indices” which can “take a variety of contractual forms depending largely on the nature of the target investors.” A tranche is defined as a certain loss range.

-6typically been the key drivers of growth in the CDO market. In addition, the underlying bond and loan secondary markets are relatively illiquid. Thus, CDOs help to improve liquidity, raising the total valuation to the issuer of the CDO structure (Duffie and Garleanu, 2001).

Participants in the CRT market have also become increasingly diverse. According to Fitch Ratings (2005), the main participants in the CDO market are lending institutions, which are usually net buyers of protection or net sellers of CDOs, and insurance companies, which are net sellers of protection and net buyers of CDOs. The most recent credit derivatives survey by the BBA suggests that while banks, securities houses, and insurance companies still constitute the majority of market participants, hedge funds have emerged as key players, both as protection buyers and sellers (Figure 2).10 According to data from Credit Suisse First Boston (CSFB), the investor base (sellers of protection) has broadened more recently to include hedge funds, proprietary traders, and the more traditional asset management industry, who participate in both the protection buyers’ and sellers’ markets (Figure 3). Even some pension funds, which have generally followed conservative investment strategies, are said to have started taking on the role of protection sellers.

–  –  –

The growth of credit derivatives has provided the impetus for the sharp growth in synthetic CDOs since the latter are easier to assemble and disperse than their cash counterparts (Figure 4).11 According to BBA (2004), synthetic CDOs make up about 16 percent of the credit derivatives market, behind CDSs, which have a 51 percent market share. Indeed, synthetic CDOs, which insured less than $400 billion of the face amount of U.S. corporate bonds in 2001, are estimated to have covered some $2 trillion by the end of 2005, according to JPMorgan. As a benchmark comparison, this would represent about 40 percent of the entire U.S. corporate bond market of almost $5 trillion.12 The demand for these instruments has been particularly strong in Europe, driven by the existing legal and taxation barriers to securitization transactions involving the true sale of underlying assets and the limited interest in these transactions for refinancing purposes (Cousseran and Rahmouni, 2005). Further, the outstanding volume of corporate bonds in Europe is much smaller than in the United States, making it more difficult to source assets for cash CDOs.

–  –  –

Within the financial system, there are increasing linkages across different financial sectors, especially among banks and insurers.13 Insurance companies are major investors in banks’ equity and debt instruments, which exposes them to risks taken by banks. Insurers also cover banks and their customers for the usual insurable risks; they provide companies with trade credit insurance, while banks often finance these “receivables,” supported by insurance.

Meanwhile, banks provide insurers with liquidity facilities to enable them to pay current claims and with letters of credit as evidence of their ability to pay future claims.



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