which are generally complex and opaque. Neither are old credit risk control tools appropriate in a market featuring:
● Many new players, and
● A high growth rate.
Some of the concepts that have so far prevailed with securitizations will be up for re-examination. For instance, today the actual net risk transfer is reduced when banks retain the first-loss positions (tranches) in structured products. This also helps to mitigate concerns that banks cease to monitor the asset quality of their customers, thereby creating moral hazard.
However, some experts suggest that if there is a massive rise in the CRT mar- ket, then such methods are insufficient and ineffectual. They do not respond to potential risks, which are sure to exist; their presence requires not only factual pricing, but also rigorous ongoing monitoring of structural issues and their under- liers. The European Central Bank had this to say on the pricing issue:
‘To the extent that long-term rates and risk premia have been driven too low in some financial markets, valuations could prove vulnerable to several potential adverse disturbances, which could leave banks exposed to greater than normal risks … There has also been growing unease about the extent of CRT outside the banking system, especially concerning the extent to which hedge funds may have taken on greater credit risk exposure … [Furthermore] very little is known about how CRT markets would function under stressed conditions.’2
With regard to the management of CRT exposure, the Basel Committee requires that if a bank has multiple credit risk transfer techniques covering a single exposure, the credit institution will be required to subdivide the exposure into portions covered by each type of CRT technique.3The risk-weighted assets of each portion must be calculated separately. Also, when credit protection provided by a single protection has differing maturities, they must be subdivided into separate products.
Prudence is highly advisable because there is already accumulating evidence that several big banks, and some smaller ones, as well as insurance companies, have become significant risk takers in CRT markets, as protection sellers (more on this later). Since a positive outcome relies not only on the transactions being well conducted, but also on their being followed up in terms of credit, market and operational risk, exposure management must be first class, including:
● Correlation analysis
● Repricing of instruments
● Real-time data capture
Risk Accounting and Risk Management for Accountants
126
Ch06-H8422.qxd 7/4/07 4:36 PM Page 126
● Online database mining
● A methodology with solid analytical tools
● Interactive visualization procedures, and
● Integrative solutions, including all banking operations.
Real-time interactive solutions, and the methodology supporting them, must appro- priately incorporate into their models every characteristic of the different CRT instruments, as well as the ways they vary in their funding: for instance, whether funds are transferred to the protection buyer when the credit risk transfer occurs, hence CRT is a funded product; or credit risk transfer takes place without funds being transferred to the protection buyer, hence CRT is an unfunded instrument.
● Cash, asset-backed securities (ABSs), collateralized debt obligations (CDOs, section 4) and loans traded in the secondary market are funded instruments.
● Synthetic collateralized debt obligations,4credit default swaps (CDSs, sec- tion 5), guarantees and insurance contracts are examples of unfunded credit risk transfers.
Another important characteristic by which CRT instruments differ is whether risk transfer from protection buyer to protection seller is direct or indirect. Credit default swaps, basket default swaps and total return swaps are examples of CRT instruments that transfer risks directly from protection buyer to protection seller.
Credit risk, however, may also be transferred indirectly from seller to buyer through special purpose vehicles (SPVs).
An equally important characteristic by which credit derivatives and other CRT instruments differ among themselves is the timing of payment. With several credit risk transfer products, when credit events occur the seller does not issue payment until loss verification and compliance checks have been carried out. By contrast, with other credit derivatives, like credit default swaps, protection pay- ments are more or less immediate.
Theoretically, all this seems straightforward. In practice, it is not that way at all, because CRTs are opaque and complex. Regulators worry that credit risk transfer reduces their ability to know where credit risk really accumulates. In the background of current worries about latent credit mega-risk transferred from big banks to other parties is that:
● Today many credit losses are buried,
● But most likely they will show up in new places later on.
Cognizant people in the CRT industry, as well as among regulators, believe that the size of credit mega-risks can cause unpredictable damage to national economies
Chapter 6
127
and the world economy as a whole. For instance, loans of about $34 billion were wiped off in the bankruptcies of Enron and WorldCom. However, millions rather than billions of losses showed up in financial statements of big banks.
● The crucial question is: where have these losses gone?
● The most probable answer is that they went to insurance firms, pension funds, hedge funds and smaller banks.
On 18 May 2005, speaking at an international conference of financial regulators in Turkey, Andrew Large, Deputy Governor of the Bank of England, issued a strong warning on credit derivatives, emphasizing the point that credit risk trans- fer has introduced new holders of credit risk, and this has happened at a time when market depth is untested and the new holders’ financial staying power is not exactly known. ‘Large risks of instability [are] arising through leverage, volatility and opacity,’ Large said.5