«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 ...»

Credit derivatives markets allow for a better distribution of risks across different segments of the financial sector. As such, the development of the credit derivatives market should be encouraged. The challenge for regulators is to implement regulatory measures and provide adequate supervision and surveillance to prevent the misuse of these instruments, while providing an environment that encourages further development of this market. This section briefly discusses key initiatives taken by the financial authorities in the world’s two biggest CRT markets, namely, the United Kingdom and the United States.

In the United States, the advent of securitization exposed major deficiencies in regulatory and supervisory practices.23 The U.S. authorities realized that while regulatory and accounting reforms were important, proper supervision of the market would require adequate resources and relevant experience on the part of supervisors.24 As a result, the Office of the Comptroller of Currency (OCC) implemented supervisory reforms related to securitization

exercises by banks. These include:

• developing a cadre of specialized experts to examine securitization programs;

• recognizing that these examinations require extraordinarily high person-hour expenditure;

developing independent valuation capabilities for the residual risk component;25 and • • obtaining information on every securitization vehicle for every bank.

In terms of banking practice, the OCC has recommended that banks should:

• encourage an independent legal and accounting review of every vehicle;

• perform “stress to breakage” risk analysis to complement their residual risk valuation;

and • put in place contingency liquidity and reserve planning.

In the United Kingdom, the Financial Services Authority (FSA) posits that understanding the extent to which real risk is transferred is key when monitoring the CRT market.26 To this end, the FSA has engaged in surveys—in particular, through the Joint Forum—to understand who See Carhill (2005).

In the United States, the regulation and supervision of banks are undertaken by the Federal Reserve and the Office of the Comptroller of Currency, as well as by individual state regulators and supervisors.

This refers to the issuing bank’s equity piece of a securitized instrument.

The approach to supervision and regulation taken by the authorities in the United States and the FSA in the United Kingdom is different, reflecting the differences in the structure and history of the banking system in each country.

- 16 the end investors are and how well the risks are managed.27 The FSA maintains a conservative approach with respect to data collection on a regular basis given its view that such exercises incur high costs and provide limited benefits, under its existing cost-benefit framework for regulation. The supervisor is also prioritizing the issue of model risk by initiating the hypothetical portfolio exercise to better understand how firms are modeling CRT instruments and to discover the challenges across firms. In the meantime, the FSA and the New York Federal Reserve are currently working with major participants in the CRT market to resolve the issue of backlogs in trade confirmations and assignments.

Meanwhile, the strengthening of reporting standards will likely improve disclosure in the financial sector. Notably, the promulgation of International Financial Reporting Standards (IFRS) points to the likelihood of more accurate valuations of structured credit and credit derivatives instruments in the financial statements.28 International Accounting Standard (IAS) 39, which is still undergoing revisions, introduces the use of fair value accounting for financial assets and liabilities of listed companies. Essentially, credit derivatives held in the trading book of a bank would have to be recorded at fair value under this standard. Within the banking book, the purpose of the instrument is key to determining its valuation in the financial statements. Credit derivatives used to hedge underlying transactions in the banking book would have to be recorded at fair value, while the same instruments may be recorded at cost if the objective is to hold them to maturity.29 There are several areas where improvements in supervision and surveillance could be effected in markets where CRT instruments are becoming more important. Specifically, the authorities should: (i) ensure that supervisory staff are always up to date with the latest techniques and tools; (ii) ensure that all paperwork relating to CRT transactions are timely and kept up to date; (iii) ensure that risk management systems are adequate to cope with stresses in the credit derivatives market and encourage continued improvements in credit risk management; (iv) require financial institutions to regularly stress test their open positions in CRT instruments, notably in structured credit exposures; (v) encourage market participants to consider richer and more consistent risk measurement techniques, in addition to formal ratings of CRT instruments; and (vi) consider the need for greater disclosure by financial institutions of their holdings in CRT instruments.

International initiatives on surveillance of the credit derivatives market include the Joint Forum and the Financial Stability Forum (see Joint Forum, 2004).

The United Kingdom adopted IFRS on January 1, 2005. The European Commission brought in fair value accounting for derivatives on November 16, 2005. The Commission initially accepted most of the proposals presented by the International Accounting Standards Board in 2004, but opted out of its recommendations on fair value accounting and on hedge accounting. It then drew up a restricted fair value option, which was approved in July 2005, and came into force on November 16, 2005, retroactive to January 1, 2005.

The financial institution is required to fully disclose the criteria for which the instrument is used and to detail how the instrument supports its investment or hedging strategy. Disclosures of details on credit derivatives is covered by IFRS 7, Financial Instruments Disclosures.

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VI. CONCLUSION

The increasing ability to trade credit risk in financial markets has facilitated the dispersion of risk across the financial and other sectors. Theoretically, the net outcome of CRTs should have a positive impact on overall financial stability and efficiency. However, there are specific risks—such as modeling risk, legal risk, and counterparty risk, among others— attached to CRT instruments which could be heightened by the still-limited liquidity in the market. Thus, a key concern is that the rapid expansion of CRT markets may actually pose problems for financial sector stability in the event of a major negative shock in credit markets.

This paper focuses on the use of structured credit products in the banking and insurance sectors and its implications for financial sector stability in the United Kingdom. Given the lack of publicly available information on the exposures of financial institutions to CRT instruments, an indirect method using VAR is applied instead, to readily available financial market data. We do not make any assumption as to whether a particular institution is long or short the credit exposure; rather, we merely assume that losses fall within the attachment and detachment points of the standardized credit derivatives benchmark, in case of defaults.

Our empirical results indicate that the structured credit market may not pose a substantial threat to financial sector stability in the United Kingdom at this point. U.K. insurance companies tend to be more conservative in taking on CRT exposures, preferring the “safer” senior tranches, while their bancassurance counterparts tend to be more exposed to the junior mezzanine tranches. The apparent diverse holdings across these major financial institutions, which are potentially active in the structured credit market, may limit the impact of any significant negative shock to the market.

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In a CDO transaction, investors have the choice of purchasing different tranches of the instrument, commensurate with their risk-return preferences. An investor could purchase the riskiest tranche, which offers the highest return by far, but which also bears the initial losses that the pool suffers from any default among all its bonds. In other words, the risk-taking investor is taking a bet that any such loss would not occur, in return for the opportunity to earn double-digit returns. Alternatively, the investor could purchase a more conservative tranche, which pays a lower return but is insulated from initial defaults in the bond pool. The super-senior, senior, mezzanine, and equity tranches bear increasing risks of defaults.

Specifically, holders of mezzanine, senior, and super-senior tranches of a CDO have some protection from the risk of loss from their respective more junior tranches.30 In order to estimate the rates of return at which to offer each tranche of the instrument, the originator (usually an investment bank) first has to estimate distribution of losses in the pool.

The distribution of losses depends largely on the correlation of default among the names referenced in the CDO. In general, the lower the default correlation, the higher the compensation paid to the equity tranche investor and vice versa. This is because lower default correlations suggest that the probability of observing a limited number of defaults is higher. The limited number of defaults is sufficient to wipe out the equity tranche investor’s capital. The opposite is true for the senior tranche investor—higher default correlations imply that the senior tranche is more likely to suffer losses, and thus the senior tranche investor would expect to be paid a higher compensation.31 The dependence of the compensation paid to mezzanine tranche investors on correlation lies between the equity and senior tranche extremes (Gibson, 2004).

The synthetic CDO is one of the most popular products derived from the regular CDO instruments.32 This instrument has the potential to intensify both the risks and returns of the regular CDO, by replacing the pool of bonds with credit derivatives, specifically, credit default swaps (CDS).33 The synthetic CDO is classified as a credit derivative. In a synthetic These tranches may also be protected by credit enhancements such as the overcollaterization of assets, reserve accounts, or trapping excess spread, which would allow them to achieve a higher credit rating than the average rating of the underlying portfolio.

From the equity tranche investor’s perspective, the higher chance of a large number of defaults (fatter tails in the distribution of the number of defaults) due to high correlation is inconsequential since the investor’s position is no longer affected beyond the first losses.

Cousseran and Rahmouni (2005) provide details on the types of CDOs available in the market, including the criteria for issuing these instruments, the nature of credit risk transfers being effected and the CDO instruments available.

A credit default swap is essentially an insurance policy that insures against a bond default. Holders of bonds could purchase credit default swaps on their bonds as protection—if the bond defaults, the seller of the CDS (seller of protection) acts as an insurer and pays the buyer. In return, the seller of the CDS receives an immediate payment up front without investing any funds, just in return for pledging to play if a default occurs.

The price of protection naturally increases with the perceived likelihood of default. Investors who do not own bonds may also purchase credit default swaps, in order to benefit from any rise in value.

APPENDIX I

- 19 CDO transaction, the credit risk on the reference portfolio is transferred using CDS

instruments:

• the special purpose vehicle (SPV) sells protection to the originator of the deal in return for agreed fees;

• the risk is then transferred from the SPV to investors through the issuance of tranches of fully-funded synthetic CDOs, credit default swaps (which are unfunded), or a combination of both (that is, partially funded CDOs).34 The risk levels of a synthetic CDO are determined by the total accumulated loss of the reference pool of assets. In a CDO, the default losses borne by a tranche range between the attachment point and detachment point. The lower bound of the range is called an attachment point and the upper bound a detachment point. For example, a 3−6 percent tranche has an attachment point of 3 percent and a detachment point of 6 percent. When the accumulated loss of the reference pool is no more than 3 percent of the total initial notional of the pool, the tranche will not be affected. However, when the loss has exceeded 3 percent, any further loss will be deducted from the tranche’s notional until the detachment point 6 percent is reached.

At this point, the tranche is wiped out.