As credit risk transfer mechanisms, securitization and credit derivatives help to sep- arate credit risks from the original transactions. They also render these transactions
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tradable in the wider market as self-standing financial instruments. That’s the good news. The bad news is a growing credit risk accumulation in balance sheets of companies that have little or no experience in managing credit exposure:
● On the one hand, there is enough evidence that credit risk transfers can make a valuable contribution to the resilience of the banking system
● On the other hand, however, this credit risk is assumed by other market play- ers, usually institutional investors, and it alters the balance in their books.
Moreover, available statistics indicate that the intermediary functions in risk transfer are typically concentrated on only a small number of bankers, who theor- etically should have first-class risk management systems. In practice, however, this is far from certain, at least in many cases. Credit derivatives can trigger pay- ment obligations equal to the entire nominal amount. Therefore, special care must be taken with appraisal of the risk involved in assuming a position.
As experience with credit risk control demonstrates, it is not enough to rely completely on ratings, because ratings are one-dimensional. Chapter 5 brought to the reader’s attention a long list of other factors – which become even more important than in granting loans because, potentially, major credit exposures may remain opaque for a number of years. Some supervisors think that because of this the risk to the banking system may be significant, as more than 80% of credit derivatives trade is in the interbank market. The remainder is shared between insurance companies, hedge funds and some other entities.
From a broader market perspective, the aforementioned statistics mean that, contrary to the generally accepted notion, there is no broadly based transfer of credit risk out of the banking system or the market as a whole. As this informa- tion becomes available, some experts suggest that, in fact, it might be that exactly the opposite is taking place because credit derivatives:
● Make it easier to enter into short positions, and
● Speculate on deterioration of an entity’s credit quality.
At the same time, a short position, however, requires that securities be borrowed in the spot market through repo transactions. Therefore, speculative transactions aiming to benefit from a company being downgraded by rating agencies are likely to operate through the market for credit derivatives.
Some experts also point out that extensive use of such instruments can accen- tuate the downside, and underline the greater volatility of the credit derivatives market as contrasted with the more traditional bond market. The upside is that, within the banking industry, securitization and credit derivatives allow the creditor
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to hedge against the default by the borrower. As such, they can be seen as a novel form of an insurance contract that:
● Separates credit risk from the original financing operation, and
● Transfers this credit risk to a third party, the risk taker.
Because a similar statement can be made with most securitized instruments, Basel II prescribes that banks must apply the securitization framework for deter- mining regulatory capital requirements for exposures arising from traditional and synthetic securitizations or similar structures that contain features common to both. This is valid for a wide range of securitized instruments, including:
● Asset-backed securities
● Mortgage-backed securities
● Reserve accounts, such as cash collateral accounts
● Credit enhancements
● Interest rate or currency swaps
● Refundable price discounts
● Tranched cover and liquidity facilities, and more.
With the exception of securitization of exposures, for which no internal ratings- based (IRB) treatment of pool assets has been specified, and under the standard- ized approach for exposures with a non-investment grade rating of BB⫹, BB or BB⫺, no distinction is made between securitization exposures held by originators and those held by the risk takers.8
Within this overall perspective of securitization’s risks and opportunities, the credit derivatives’ goal is to make the separate credit risk marketable. Notice that this can also be done through existing insurance-type products, such as guaran- tees. One of the reasons credit derivatives are taking the upper ground is that mathematical analysis and information technology make it possible to:
● Try to isolate risks, and
● Combine them in different ways than those used traditionally.
One of the more important is lack of expertise in doing just that, because these derivative products must be marketable. Marketability requires a high degree of standardization, partly provided through the use of master agreements advanced by the International Swaps and Derivatives Association (ISDA) and partly by market response.
The prevailing opinion is that, as standardized and tradable financial instru- ments, credit derivatives expand their horizon of applications. Standardization
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relieves the need for individual verification, and tradability sees to it that risk vendors may not even have to own the obligation that they sell to risk takers; they may be acting purely as intermediary.
For seller, buyer and intermediary, risk management should be seen as an integral part of the cost of transferring credit exposure to third parties. For marketability and credit risk management purposes, the originator bank may initially transfer the credit risk arising from the underlying portfolio to an independent special purpose vehicle (SPV), thereby separating the credit risk on the securitized port- folio from other exposures that are its own.
In other cases, the reference obligations are not sold directly to the special pur- pose vehicle. Instead, they remain on the originator bank’s balance sheet, along with the credit risk that they represent. Some practitioners believe that this is a negative, as far as diversification of credit exposure is concerned.
For the economy as a whole, high concentration of credit risk, which is gener- ally characteristic of derivatives markets, is worrisome from a systemic risk view- point. In the opinion of some experts, the rapidly growing derivatives trades add to global financial imbalances, which, from a financial stability perspective, represent an important vulnerability for the global financial system – with disturbances leading to changes sparking large trade and price adjustments.
Central bankers also think that a potential withdrawal from the market by one or two of the major intermediary banks in derivatives is sure to result in a serious short-term liquidity risk. In many cases it is very difficult to distinguish a severe short-term illiquidity from a credit institution’s insolvency, and the former might precipitate the latter.