Credit risk transfer by EU banks: activities, risks and ... · Credit risk transfer by EU banks: activities, risks and risk management May 2004 EXECUTIVE SUMMARY This report, prepared

CRED IT R I SK TRANSFER BY EU BANKS :ACT IV I T I E S , R I SKS AND R I SK MANAGEMENT

MAY 2004

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CREDIT RISK TRANSFER BY EU BANKS:ACTIVITIES, RISKS AND RISK MANAGEMENT

MAY 2004

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Credit risk transfer by EU banks: activities, risks and risk managementMay 2004

FOREWORD 5

EXECUTIVE SUMMARY 6

1 INTRODUCTION 10

2 FEATURES OF CRT MARKETS 11

2.1 Overall market structure 11

2.2 The role of banks in CRT markets 14

2.3 Other institutions in CRT markets 15

2.4 Banks’ views on latest marketdevelopments 15

3 BANKS’ INVOLVEMENT IN CRT 17

3.1 Motivations for and against CRTactivity 17

3.2 CRT activities and instrumentsused 17

3.3 Net protection buying or selling? 20

4 THE FUNCTIONING OF CRT MARKETS 21

4.1 Sector and geographical locationof counterparties 21

4.2 Market concentration 22

4.3 Potential problems related tomarket structure 22

4.4 Limitations to the use of CRTmarkets 24

5 CRT RISKS AND RISK MANAGEMENT 25

5.1 Sources of risk 25

5.2 Risk management 27

5.3 Impact on banks’ loan losses overthe business cycle 29

6 IMPLICATIONS OF CRT FOR BANKS’STRATEGIES 31

7 POLICY IMPLICATIONS 32

7.1 Macro-prudential oversight 32

7.2 Micro-prudential oversight 35

CONTENT S

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FOREWORD

The purpose of publishing this report is to sharewith a broader audience the main findings of arecent and extensive survey of EU banks’involvement in credit risk transfer (CRT)markets and the risks they face there. Thesurvey was carried out by the BankingSupervision Committee (BSC) of the EuropeanSystem of Central Banks, a forum of co-operation among the European Central Bankand national central banks and supervisoryauthorities of the EU.

The BSC continuously monitors thedevelopment of the sources of risk that banksface. More generally, it assesses bankingstability and explores measures that might bewarranted to maintain financial stability. Theexponential growth, complexity and relativeopaqueness of CRT instruments such as creditderivatives and collateralised debt obligationshas made it necessary for monetary andsupervisory authorities to pay close attention tothese markets.

CRT markets allow large amounts of credit riskto be reallocated across the financial and non-financial sectors of the economy. The report’soverall assessment of trends in this market ispositive. Improvements in the ability of banksand other financial institutions to diversify andhedge their credit risks are helping the financialsystem to become more efficient and stable. Forexample, the CRT markets enable banks toreduce their sensitivity to fluctuations in localmarkets or traditional lines of business.Nevertheless, the report identifies importantissues for authorities and market participants toconsider. These include transparency and soundrisk management practices, upon which theoverall integrity and stability of the marketdepend.

Looking ahead, the banks surveyed expect CRTactivities to continue growing at a rapid pace.This means that authorities must continue tomonitor them. Useful cross-sectoral co-operation between authorities – coveringbanking, securities and insurance sectors – hasalready started within the EU. Global initiatives

FOREWORDare also under way. This work will provide afuller picture of the sharing of credit risk acrossthe different segments of the financial system.

Jean-Claude Trichet

President of the European Central Bank

6ECB cCredit risk transfer by EU banks: activities, risks and risk managementMay 2004

EX E CU T I V E S UMMARYThis report, prepared by the BankingSupervision Committee of the ESCB, examinesthe activities of EU15 banks in credit risktransfer (CRT) markets and the risks they facein these activities.1 It is the most comprehensivesurvey undertaken to date by EU supervisorsand central banks on the use of CRTinstruments by banks. Over 100 banks from 15EU countries plus five large, internationallyactive, non-EU banks and securities housesoperating in London were interviewed. Most ofthe interviews were conducted in the latter halfof 2003. The report covers small and medium-sized banks as well as the major counterpartiesin CRT, and it focuses on the fastest growingCRT instruments, which can also be traded incapital markets. These include credit derivativeinstruments (credit default swaps (CDSs),credit linked notes (CLNs) etc.) and structuredproducts (asset backed securities (ABSs) andsynthetic collateralised debt obligations(CDOs)).

MOTIVATION FOR THE INVOLVEMENT OF BANKS INCRT ACTIVITY

The different ways in which the surveyed bankswere involved in CRT activities can beseparated into two broad categories. “Portfoliomanagement banks” use CRT instruments forcredit risk shedding (protection buying) and/orrisk taking (protection selling) purposes.“Intermediaries” trade CRT products activelyand make markets in credit derivatives. In thisactivity, banks typically aim to run matchedcredit risk positions.

The survey reveals that for the portfoliomanagement banks that were involved in risk-shedding, the main motivation was to reduce therisks related to single entities, to obtain capitalmanagement benefits and regulatory capitalrelief, and to access funding throughsecuritisation. For the banks that used themarket to take on credit risk, the main reasongiven was to diversify credit risk by acquiringclaims on firms that would otherwise not beaccessible to them through regular client

acquisition. Some banks also hoped to improvetheir income via higher-yielding CRTinstruments. In intermediation, the generationof fee income was given as the main objective.

SIZE OF CRT ACTIVITY

For the majority of banks surveyed, theimportance of CRT instruments remains limited.However, some banks already make significantuse of CRT markets. In a few countries, the useof structured products to shed risk was reportedas being particularly high. Credit derivativeswere generally used less to shed risk thanstructured products. Risk shedding throughcredit derivatives was often below 1% oftotal assets, although several banks reportedsignificantly higher figures. As regards risktaking, some individual banks reported makingrelatively substantial use of structured productsor credit derivatives, with a volume amountingto close to 10% of total assets.

With regard to intermediaries, the surveycovered around ten institutions located inGermany, France and the United Kingdom thatactively trade in global CRT markets. However,there are also other EU banks with significantintermediary functions (in Belgium, theNetherlands, Spain and Italy).

Banks which use CRT instruments for portfoliomanagement purposes were reported as dealingmostly with the large intermediary banks (oftenwith significant concentrations of counterpartyexposure). In all, over 80% of the total CRTactivity of EU banks took place withcounterparties resident outside their respectivedomestic markets, with few exceptions. Londonwas reported as being the main internationalfinancial centre for CRT activity.

1 The interviews were conducted and the report finalised beforethe ten new Member States joined the EU. For the sake ofsimplicity, throughout the report “EU” refers to countries thatwere members of the EU before 1 May 2004.

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EXECUTIVESUMMARY

NET RISK TRANSFER BY BANKS THROUGH CRTMARKETS

On the basis of notional amounts, banks fromBelgium, Spain, Ireland (medium-sized banks),France, Italy, the Netherlands, Portugal andSweden were mostly reported as being netprotection buyers. Net protection sellers weresmaller regional German banks, as well asDanish, Greek, Luxembourg, some Austrianbanks and two large Irish banks. However, theactual net positions (typically only a fraction ofthe gross volume) can be difficult to measure.

Trading in CRT instruments, which accountsfor the bulk of the volume in CRT markets, wasfound to be increasingly a bank-to-bankbusiness. At the time the survey was conducted,there were signs that the investment appetite ofsome insurance companies that had earlierentered the market was declining quitesignificantly. It was unclear whether thisreflected a permanent change in strategy or thenarrowing of credit spreads through 2003.However, some insurance companies may stillhave significant open risk positions in CDOsand other ABSs. As the survey did not cover therisks of non-bank financial institutions, scoperemains to collect more information.

According to some reports, intermediary bankshad increasingly retained the riskiest first-loss(equity) tranches of synthetic CDOs (and alsosenior tranches) at least temporarily, therebyreducing the amount of net risk transfer bybanks.

The involvement of hedge funds was reported tobe increasing. Hedge funds have helpedintermediary banks to hedge their short CDOpositions. They have also become increasinglywilling to take on credit risk in the form ofCDOs and distressed debt.

BANKS’ VIEWS ON THE FUNCTIONING OF CRTMARKETS

In general, banks considered CRT markets to befunctioning well, although some said thatsecondary market liquidity could be improvedin some smaller market segments. Banks alsosaw scope for improving trading in debtinstruments issued by domestic firms andconsidered as a shortcoming the fact that themarket is limited to large, investment-gradeobligors. Importantly, there was a widespreadperception among the banks interviewed that theCRT markets are opaque.

Interviews with major market participantsindicated that the rapid pace of growth andinnovation in the CRT markets continued in2002 and 2003 and that market liquidity hadimproved markedly. The growth in trading ofCDSs and synthetic CDO tranches, as well asthe emergence of single-tranche CDOs andCDOs of CDOs, were seen to be the mostdynamic aspects of the market in 2003.However, single-name CDSs continued to bethe most important instruments for hedgingindividual exposures. The banks surveyedunderlined the importance of the guaranteesoffered by monoline insurance companies –which are specialist providers of guarantees –for the functioning of CDO markets.

Traditional ABS structures have also gainedmomentum and are expected to continue to playan important role for EU banks, includingregional banks. Besides reducing fundingpressures for banks, they can offer enhancedliquidity to investors.

The potential for disruption of the CRT marketswas, in general, considered to be small.However, some systemic events that could posechallenges to market functioning wereidentified. These included the exit of a majorcounterparty, a large credit event leading tosettlement difficulties, or fraud leading to a lossof confidence in the market. Additionally, legal,tax, or regulatory changes were identified asfactors that could undermine market confidence.


A double default of a major underlying firm anda counterparty, although highly unlikely, couldpotentially test the market, since the associatedlosses could be larger than in correlated eventsin other derivative markets.

RISKS RELATED TO CRT TRANSACTIONS

Banks were also surveyed on the types of riskthat could be faced by individual participants inCRT markets. Several different types wereidentified, and the banks provided their viewson the most important risks.

In portfolio management, protection sellersranked credit risk and model (includingpricing) risks , and to a lesser extent liquidityrisk (the inability to hedge or sell instrumentswhen necessary to adjust risk profiles), asimportant sources of risk. Investors in CDOssaw model and rating risks (including theratings of monolines) as well as a lack oftransparency in the market as being the mostimportant sources of risk.

Protection buyers saw counterparty risk(perhaps reflecting the absence of collateral ornetting agreements) and, in some instances, thelegal robustness of documentation as potentialsources of risk. Correlation risk (betweenreference entities and counterparties) was alsoput forward as a potential source ofvulnerability. In the case of the originators ofCDOs, a major source of risk was seen to bereputation risk as regards reference entities, i.e.the risk that the underlying assets may notperform well. Some originators of CRTinstruments also saw retained first-losspositions in assets sold as sources ofvulnerability. Broader risks includedregulatory risk (the risk of changes such as theintroduction of a requirement to consolidatesecuritisations on the balance sheet) andliquidity risk (the loss of a funding source).

In intermediation, credit risk (which is oftendynamically hedged), liquidity risk and model(including pricing) risks were seen as the most

important sources of risk. Correlation riskbetween reference entities, counterparties andcollateral was also highlighted. Counterpartyrisk was seen to be less important, presumablybecause of the extensive use of collateral andnetting agreements. However, banks noted thedifficulty of gauging their exposure to monolineinsurance companies, both directly ascounterparties and indirectly because of“wrapped” (i.e. guaranteed by monolines)CDOs that banks had arranged. A minor sourceof risk arose from the possibility of settlementbacklogs. This is because confirmations oftransactions have not kept pace with marketinnovations.

Legal and documentation risks were consideredsignificant potential sources of risk by manyrespondents, irrespective of their role in CRTmarkets. However, attempts have been made toimprove the contractual framework for CRTinstruments, and significant progress hasalready been achieved.

RISK MANAGEMENT

Most portfolio management banks stated thatthey carefully assess risks before entering intonew types of CRT transaction. Existing riskmanagement tools (internal and external ratings,market-based estimates of probability of defaultand credit portfolio models) were largelyregarded as adequate as long as a bank’s CRTactivities remained relatively limited.

Banks involved in intermediation saw a need forsophisticated risk management systems. Thesebanks reported that they have put systems inplace based on enhanced risk models andinformation technology: credit risk limits thatare marked-to-market daily, consolidation ofcredit risk positions across business lines,correlation estimates based on stressed marketconditions, and strengthened internal creditallocation processes. Banks indicated that theymitigated the risk of high correlation betweenthe borrower (the underlying entity) and theprotection guarantor in several ways, including

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EXECUTIVESUMMARY

collateral agreements, executing trades on afunded basis and restricting transactions on thebasis of correlation modelling. The growth inCDOs has highlighted the risks fromcorrelations, price jumps and reliance on marketliquidity for dynamic hedging. At the sametime, the increased availability of credit indiceshas provided an important tool to hedge CDOtranches.

BUSINESS MODELS AND STRATEGIES

CRT instruments allow credit risk to be traded,thus blurring the borderline between bankingand trading books. CRT is likely to influencebanks’ business models over the long run,particularly as regards larger corporatecustomers. However, it is likely to have fewerconsequences for lending to small and medium-sized enterprises.

According to the banks surveyed, the changesin business models and strategies have not beendramatic so far. However, they foreseeimportant developments in the future: (i) thetraditional strategy of granting and holdingloans will tend to shift towards attracting loansand transferring them to the parties most willingto bear the risk; (ii) a more integrated approachto credit risk assessment and management islikely to develop, including more market-basedpricing; (iii) increased banking competition isexpected, leading to a greater focus oncomparative advantage, and, in Europe,increased consolidation in the banking sector.

POLICY IMPLICATIONS

The survey findings suggest some new policyimplications arising from the use of CRTinstruments and bring out new aspects ofpreviously recognised implications. Suchissues are grouped in the report under macro-prudential and micro-prudential oversight.Supervisory authorities and central banks arepaying increasing attention to this area – asevidenced by the preparation of this report. The

authorities are ensuring that the risks toindividual banks and, more broadly, financialstability remain in check. Further work toexamine linkages across the sectors of thefinancial system is also ongoing in otherEuropean and international fora.


This report, prepared by the BankingSupervision Committee of the ESCB (BSC)2, isbased on local interviews with over 100 banksfrom 15 EU countries plus five large,internationally active, non-EU banks andsecurities houses operating in London.3 Mostof the banks were chosen based on their knownCRT activities. The majority of the interviewswas conducted in the latter half of 2003. Onethird of the banks were large internationalinstitutions, while two thirds were smaller(national or regional) banks. Interviews withthese banks focused on asset-backed securities(ABSs), including cash collateralised debtobligations (CDOs), as well as synthetic CDOsand credit derivative instruments such as creditdefault swaps (CDSs) and credit-linked notes(CLNs), etc. These instruments are described inBox 1.

A number of earlier studies set the stage for thisreport. The analysis builds largely on theconceptual framework and market descriptionpresented in a report prepared by the Committeeon the Global Financial System (CGFS).4

Useful information has also been provided invarious market reports prepared byFitchRatings and Standard & Poor’s.5

The main body of the report, which sets out theinterview findings in detail, is organised asfollows. Section 2 discusses the structure of theCRT markets and the latest developments inthese markets reflecting the views of majormarket participants included in the survey.Section 3 presents a summary of the mainmotivations that lie behind the involvement ofbanks in CRT markets, as well as the extent ofactivities of EU banks. Section 4 reports onbanks’ views regarding the functioning of CRTmarkets, and Section 5 discusses the risks facedby banks as well as risk management issues.The views of surveyed banks as to theirbusiness strategies are summarised in Section6. The report concludes with a discussion ofkey policy implications emerging from thesurvey (Section 7).

1 I N TRODUCT I ON

2 The BSC is a forum of cooperation among national central banksand supervisory authorities of the EU and the ECB.

3 The number of banks interviewed by country was the following:Belgium 3, Denmark 4, Germany 10, Greece 3, Spain 4, France3, Ireland 46, Italy 4, Luxembourg 3, the Netherlands 7, Austria8, Portugal 4, Finland 3, Sweden 4, United Kingdom 5 (+ 5 non-EU). The Irish authorities conducted extensive interviews with alarge sample of banks in order to obtain a broader view of theactivities of Irish banks in CRT, rather than focus only on banksthat were already known to be active in the CRT area. However,this does not affect the discussion and conclusions of the report.As a result of the uneven number of banks per country, anyquantitative data are not totalled in the report.

4 See “Credit Risk Transfer”, CGFS, December 2002.5 See “Global Credit Derivatives: Risk Management or Risk?”,

FitchRatings, March 2003; “Global Credit Derivatives: AQualified Success”, FitchRatings, September 2003; and“Demystifying Banks’ Use of Credit Derivatives”, Standard &Poor’s, December 2003.

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2 FEATURESOF CRT

MARKETS2.1 OVERALL MARKET STRUCTURE

CRT is a well-established feature of financialmarkets. Credit risk has been transferred betweencounterparties since at least the 1970s, whenbank loan syndication emerged as a widespreadactivity, followed shortly afterwards by the nowtraditional securitisation. But, even before that,credit risk had been transferred through loanguarantees and credit insurance.

CRT activities can be classified under twoheadings: “banking/capital market solutions”and “insurance solutions” (see Table 1). In thelatter category, typical insurance products(credit insurance, financial guarantees) cannotbe traded in the capital market, but are boughtby customers of insurance companies and areheld until the insurance protection expires. Thisreport does not cover these products directly,although it does make some reference to the roleof specialised monoline insurance companies inproviding guarantees as they are crucial for thefunctioning of the CDO markets.

2 F E ATUR E S O F C RT MARKE T SBanking/capital market products such as creditderivatives and ABSs are instruments that canbe bought and held by investors, such as banksand insurance companies, but they can also beactively traded. This report focuses on theseinstruments. While the provider of an insuranceproduct can only be an insurance company, theprovider of capital market CRT instruments canbe any (though usually financial) company.

The CRT markets have grown very rapidly inrecent years due to the progressive demand forand development of new innovative instrumentsin the banking/capital market sphere. Theseinstruments are also increasingly traded. Anumber of factors have contributed to thisgrowth. These include the increased focus offinancial institutions on risk management andrisk diversification; lower funding costsassociated with taking risk positions; new risk/return profiles offered by structured products;and the availability of “arbitrage” gains arisingfrom tax, accounting and capital regulations.

“Banking/capital market solutions” “Insurance solutions”

Credit Structured products Loan sales Surety bonds Underwriting Creditderivatives of guarantees insurance

Asset-backed Syntheticsecurities products

Typical Credit default Asset-backed Synthetic Syndicated Construction, Financial Trade creditproducts swap, commercial CDO loans Performance, guarantees insurance,

Total return paper, Customs bonds Exportswap, Mortgage- credit

Credit spread backed insuranceoption, securities etc.,

Credit-linked Collateralisednote debt obligation

(CDO)

Typical Banks (as well as insurance companies, Commercial Banks, other financial institutions,protection other financial institutions) banks non-financial firmsbuyers (risk (secondaryshedding) loan market)

Typical Banks and investment banks, insurance Various Not relevant; no transfer to third partiesprotection companies, other financial institutions investors typically occurssellers (risktaking forinvestmentpurposes)

Typical Banks and investment banks Commercial Specialised Monolines Creditintermediaries/ banks surety (and insuranceproviders companies and multilines) companies(insurance multilinessolutions)

Table 1 Overview of the credit r isk transfer markets


Box 1

CRT INSTRUMENTS

A. Definitions 1

Structured products 2

Asset-backed securitiesAsset-backed securities (ABSs) transfer the risk inherent in a pool of related assets from theoriginator of the assets to investors in the ABS. Popular asset pools include mortgages, creditcard receivables and car loans. Collateralised debt obligations (CDOs), which are based onpools of corporate debt, are examples of ABSs.

ABSs depend on the performance of the underlying assets to deliver interest and principalpayments to investors. In the event of non-performance, losses are allocated to investorsaccording to the seniority of the issued securities. To protect against the effects of non-performance, investors may also be offered some “credit enhancement”. Common forms ofcredit enhancement include collateral, equity capital and third-party insurance.

Synthetic collateralised debt obligationsA synthetic CDO redistributes the risk inherent in a portfolio of credit default swap (CDS)contracts across a number of tranches that have a strict seniority ordering. If defaults occur,protection payments are initially triggered from sellers of the most junior tranche, which is oftencalled the equity tranche. If default losses exceed the “detachment point” of the equity tranche,and hence pass the “attachment point” of the second most junior tranche (one of the “mezzanine”tranches), protection payments are then required from protection sellers with this tranche. Thispattern continues through any remaining mezzanine tranches, to senior and super-seniortranches. A synthetic CDO produces equivalent payoffs to a traditional CDO (see above) byusing credit derivatives but avoids the need to fund the underlying debt investments.

Credit derivatives

The cashflows of credit derivative instruments are determined by the credit quality of anunderlying asset or assets. Examples of credit derivatives are:

Credit default swapsA credit default swap (CDS) transfers the credit risk associated with a particular corporate orsovereign borrower – the “reference entity” – from one party (the protection buyer) to another(the protection seller). This is achieved by a net transfer from the protection seller to theprotection buyer that is equal to the difference between the face value and market value of thereference entity’s debt. The transfer is made only if a “credit event” occurs. Credit eventsinclude the bankruptcy of the reference entity, the restructuring of its debts, or a failure to meetits scheduled debt repayments. Most CDS contracts are based on physical settlement, where theprotection seller pays the face value of the debt to the protection buyer in return for the

1 It should be noted that the categorisation of CRT instruments can vary from source to source.2 In this report, synthetic CDOs are grouped under the heading of structured products. It should be noted, though, that synthetic CDOs

could also be grouped under credit derivatives since they are based on these instruments.

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2 FEATURESOF CRT

MARKETScorresponding securities. The alternative basis is cash settlement, where the protection sellersimply pays the difference between face value and market value in cash. In return for thisinsurance, the protection buyer pays a regular (usually quarterly) premium to the protectionseller. Premium payments cease if a credit event occurs.

Portfolios of credit default swaps and indicesCDS portfolios are indices constructed from numerous single-name CDS contracts. Protectionon indices may be bought or sold by market participants who wish to hedge or express views onthe future direction of particular sectors of the credit market. TRAC-X and iBoxx are the twomost-traded index families. They are both made up of numerous regional and sectoral sub-indices. Any credit events affecting these indices are settled physically and the weights ofaffected CDS contracts are adjusted in relation to the scale of losses.

Credit-linked notesA credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from thenote issuer to the investor. The issuer receives the issue price for each CLN from the investorand invests this in low-risk collateral. If a credit event is declared, the issuer sells the collateraland keeps the difference between the face value and market value of the reference entity’s debt.Any residual is transferred to the investor. The issuer benefits from insurance against credit riskand pays a regular coupon to the investor. In contrast to a CDS, where the protection buyer isexposed to counterparty risk, the issuer of a CLN is exposed to the risk of a decline in the valueof collateral.

Credit spread optionsA credit spread option grants the buyer the right, but not the obligation, to purchase a bondduring a specified future “exercise” period at the contemporaneous market price and to receivean amount equal to the price implied by a “strike spread” stated in the contract. Spreads may bebased on government bond yields, asset swap rates or prices. The exercise period may be asingle date (European options), multiple dates (Bermudan options) or a range of dates(American options).

Total return swapsA total return (TR) swap is a bilateral financial contract under which one party (the TR payer)makes payments equal to the total return on a security to another party (the TR receiver). Inexchange, the TR receiver pays the TR payer its (fixed or floating) funding cost plus a spread.Total returns are equal to capital gains plus any coupons, interest or dividends paid on thesecurity. Total return swaps are often based on equities, equity indices, bonds or portfolios ofloans or mortgages. In contrast to most credit derivative instruments, where cashflows aredetermined by particular credit events, total return swaps transfer insurance against loss ofvalue regardless of the underlying cause.

B. Instrument characteristics

CRT instruments can be classified by their specific characteristics. One key characteristic is thenumber of credit items involved in the risk transfer. Instruments that transfer the credit risk ofa single borrower are known as “single-name” instruments and include credit default swaps andtotal return swaps (as well as guarantees, insurance contracts and loans traded in the secondary


markets). Instruments that transfer the credit risk of several borrowers are known as “portfolio”instruments, for example default swap baskets (including first-to-default swaps), credit indices,and ABSs, including single-tranche CDOs.

A second characteristic by which CRT instruments vary is their funding basis. If funds aretransferred to the protection buyer when the credit risk transfer occurs, the CRT instrument is afunded instrument. ABSs, including cash CDOs (as well as loans traded in the secondarymarket), are examples of funded credit risk transfers. If, by contrast, the credit risk transferoccurs without funds being transferred to the protection buyer, the CRT instrument is anunfunded instrument. Credit default swaps and synthetic CDOs are examples of unfunded creditrisk transfers, as are guarantees and insurance contracts.

A third characteristic by which CRT instruments differ is whether the risk transfer is direct,from protection buyer to protection seller. Credit default swaps, basket default swaps and totalreturn swaps are all examples of CRT instruments that transfer risks directly from protectionbuyers to protection sellers. Alternatively, credit risk may be transferred indirectly from sellerto buyer via special purpose vehicles (SPVs). For instance, in ABS structures loans, bonds orreceivables are transferred to an SPV that holds them as collateral to back the securities issuedto investors.

A final characteristic by which credit derivatives and more traditional CRT instruments differ isthe timing of payment when credit events occur. For credit default swaps and other creditderivatives, protection payments are more or less immediate. By contrast, insurance contracts,for example, do not issue payment until loss verification and compliance checks have beencarried out.

2.2 THE ROLE OF BANKS IN CRT MARKETS

Banks represent the major share of CRT marketactivity. Their involvement falls into two broadcategories. First, banks use CRT instrumentsfor purposes such as diversifying or hedgingrisks in their banking book or to improvefunding (see Section 3). These activities aregrouped under the heading of portfoliomanagement.

Second, some large universal banks areinvolved in (matched) intermediation of CRTinstruments.6 In this activity, the (“trading”)banks have typically largely offsettingpositions in CRT instruments. Thus, they do notengage in major credit risk shedding or taking,but provide investor services by devising andintermediating CRT products and makingmarkets for credit derivatives. One should notethat individual banks can be involved in both

portfolio management and intermediationactivities depending on their strategy.

In both portfolio management andintermediation activities, banks can be engagedin the origination of CRT instruments. In thecase of portfolio management, a bank generatesCRT products from its balance sheet assets. Theusual motivation is improved funding or capitalmanagement or relief (see below). In the case ofintermediation, a bank can create CDOs from aset of available loans or bonds (not necessarilyassets on its own balance sheet) to meetcustomer demand for funding and investmentopportunities at the same time.

6 The most cited counterparties in the survey were J.P. Morgan,Deutsche Bank, BNP Paribas, Citibank, UBS, Dresdner Bank,Goldman Sachs, Lehman Brothers and Crédit Suisse First Boston.See also the list of the top 25 counterparties in credit derivatives(commonly quoted counterparties) in “Global CreditDerivatives: A Qualified Success”, FitchRatings, September2003.

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2 FEATURESOF CRT

MARKETS2.3 OTHER INSTITUTIONS IN CRT MARKETS

Even though the survey did not cover otherfinancial and non-financial institutions, thissection provides a short overview of theactivities of these institutions as reflected inbanks’ answers.

Insurance companies are the largest buyers ofcredit risk outside the banking system,motivated by the opportunity to diversify theirasset holdings (which have traditionallyincluded a significant component of credit risk).Different insurance companies tend to focus ondifferent CRT markets. Life insurancecompanies, for example, tend to purchasefunded instruments such as ABSs, whereasgeneral insurers have tended to acquireunfunded instruments, such as portfolios ofCDSs. Credit risk is not new for the insuranceindustry. However, investment in the moresophisticated CRT products is quite distinctfrom the traditional ways of taking on creditrisk in loans or bonds or via credit insuranceproducts (see Table 1).

In some countries, insurance companies are notallowed to enter directly into derivativetransactions. However, they can instead sellconventional insurance contracts to an entityknown as a “transformer”, which then buyscredit risk through derivative contracts.Transformers are located in jurisdictions suchas Bermuda where these restrictions do notexist.

Monoline insurers have developed theirbusiness from insuring only US municipalbonds in the 1970s to selling protection onsenior or super-senior AAA-rated tranches ofABSs. This insurance is likely to be called onlyin the event of very extreme market events.

Managed investment funds, e.g. hedge fundsand pension funds, are also important sellers ofprotection, often taking positions via portfolioinstruments, such as ABSs. Growth in themanaged funds market resulting from theintroduction of private pension schemes in a

number of countries may further enhance thispart of the CRT market. Additionally, in the lastfew years hedge funds have become more activeon both sides of the market (selling or buyingprotection) in single-name instruments, wherethey have used a variety of trading strategies in,for example, convertible and distressed debt.

Non-financial companies make relatively littleuse of novel, tradable CRT instruments atpresent. Some have entered the CRT markets bysecuritising their receivables or transferring therisk inherent in trade credit extended tocustomers (or by purchasing risk insurance, forexample on trade credit).

2.4 BANKS’ VIEWS ON LATEST MARKETDEVELOPMENTS

The banks surveyed reported that the marketsfor CRT instruments evolved very rapidly in2002 and 2003, both globally and in the EU.Innovative instruments continued to develop,notably single tranche CDOs and other types ofrepackaging such as principal-protected notesand combo structures, as well as credit indices.These instruments also experienced thestrongest growth. The market went through acyclical turn in credit spreads, with acompression of spreads from around autumn2002 onwards.

CRT market liquidity has improved markedly.Banks reported that some CDSs have becomemore liquid than the underlying cashinstruments, such as corporate bonds. Some200 corporate names, mostly large companies,were reported to be actively traded as CDSs.Around 1,500 CDS names were traded in total,most of which were investment grade. The CRTmarket has so far focused on high quality creditrisks (underlying assets mainly of investmentgrade), but the report found some evidence ofincreasing involvement of lower rated orunrated assets.

Credit indices, including iBoxx and TRAC-Xhelped improve liquidity in the credit


derivatives market in 2003. This market hasbecome quite sophisticated in a short period oftime because it has been able to take itsunderlying “technology” from other markets.The banks surveyed expected credit spreadindex trading to grow further in volume.

Although they have been available for manyyears, traditional securitisation structures havealso gained considerable momentum in the EU.Banks generally held the view that thesestructures will continue to play an importantrole in the CRT activities of EU banks,including regional banks. A significant factorwas seen to be the enhanced liquidity offered toinvestors by the securitised instruments. Theenhancement has been particularly valuable inABSs and CDOs of corporate bank loans(sometimes referred to as collateralised loanobligations or CLOs), for which liquidity in theunderlying market has been perceived to belimited. It would appear that re-securitisation(known as CDOs of CDOs) has also beenmotivated to a significant extent by desire forenhanced liquidity, rather than a means ofseeking increased leverage. However, at a timeof cyclical compression of corporate spreads,CDOs of CDOs have also been a means toobtain higher yields. In addition, CDOs ofCDOs improve diversification, although theyincrease opacity regarding information on theunderlying assets.

With regard to country-specific developments,in particular in Germany, the “True SalesInitiative” may substantially foster thedevelopment of a large-scale securitisationmarket.

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3 BANKS’INVOLVEMENT

IN CRT

3 B ANK S ’ I N VO LV EMENT I N C RT3.1 MOTIVATIONS FOR AND AGAINST CRT

ACTIVITY

In general, the banks surveyed cited verysimilar motivations for their various roles inCRT markets. However, there were some keydifferences. These differences reflected the sizeof the economy, nature of the financial markets,the bank’s customer base and portfoliostructure, as well as its strategy vis-à-vis thenew instruments.

On the portfolio management side, the mainmotivation for a bank to buy protection wasgenerally to hedge both aggregate risk andsingle-name concentration risk. Some banks feltthat this role may intensify in the future, asbanks that are active intermediaries of CRTinstruments have an increasing need fordynamic hedging.

With regard to portfolio management byoriginating CRT instruments, the key specificmotivations were reported to be capitalmanagement (regulatory arbitrage and capitalrelief), improved access to funding viacollateral made available by securitisation,followed by the need to manage individualcredit lines and concentrations related tocustomers. In some countries, securitisationwas driven by funding and liquidity needs dueto high lending growth. CRT instruments werealso seen to enable banks to reshape businessdevelopment strategies by allowing them toestablish long-term relationships withenterprise counterparties without creatingexcessive exposure to these clients. Some bankshave reportedly engaged in CRT origination togain further knowledge of these instruments.

The key motivation for banks to sell protectionwas the diversification of risk. In somecountries, a need to find profitable additionalinvestments was also regarded as an importantmotive, especially if the volume of depositsoutweighed that of loans.7 Some banksconsidered CRT business to be a goodsubstitute for traditional credit businesses sinceit was seen to provide higher margin income

than e.g. corporate bonds of similar rating.Protection selling was also seen to provide themeans to diversify the product range offered tocustomers as well as to optimise economiccapital.

Intermediation was reported to be conductedmainly to earn fee income. It was also seen tohelp broaden the services offered to customersthrough product innovation and market makingand to provide access to a new range ofinvestors. Managing a bank’s own portfoliowas mentioned to be of secondary importance inthis activity.

As regards banks which reported that they werenot involved in CRT, many did not see theirinactivity as a disadvantage. Many of them saidthat their customers had no need for suchinstruments. Such banks also often felt thattheir information systems were notsophisticated enough to deal with the risksinvolved. They said that even though reasonsfor smaller institutions not to engage in CRTwill be partly offset by the need for funding,improved risk diversification and new highyielding products, they will remain largely validin the years to come.

3.2 CRT ACTIVITIES AND INSTRUMENTS USED

According to survey reports, CRT is ofrelatively limited importance in the EU inaggregated terms. However, several individualbanks already make significant use of CRTmarkets, while the activities were reported tovary greatly with regard to the instrumentsused.8 It should be noted that banks with thehighest CRT involvement, as measured by inrelation to total assets, were not located incountries where the large, internationallyactive, intermediary banks were resident.For example, as regards protection buyingfor portfolio management purposes, certain

7 This was the case particularly in Luxembourg.8 Caution is warranted when interpreting these results as detailed

information was not available for all countries on the importanceof different instrument classes.


Spanish and Portuguese banks were reported tohave quite a high involvement in structuredproducts, as measured against the total assets ofthese banks (see Table 2).

Most banks were involved to at least somedegree in origination. This varied from arelatively limited involvement in countries suchas Luxembourg, Netherlands, Austria, Finlandand Sweden to representing a large proportionor even the majority of CRT activity in Spain,France, Italy and Portugal (structuredproducts). In Denmark, Austria, Portugal,Finland and Sweden, trading in CDSs andorigination of CDOs was reported to be limitedby a small market and the availability of only afew corporate names suitable for suchinstruments. Partly owing to these limitations,origination often took the form of securitisationof mortgages (see below).

While markets were reported to be dominated byonly a few large intermediary banks (seeabove), intermediation was considered torepresent a significant share of the overallnotional CRT volumes.9 As regards netpositions of intermediary banks, they werereported to usually cancel each other out orsometimes weigh on the side of net protection

buying. The intermediation role was seen aspotentially becoming even more important in thefuture, as corporate clients and also governmententities/municipalities are increasinglyinterested in originating securities, in particularABSs, which banks could sell on to investors.

CREDIT DERIVATIVESThe use of credit derivatives seemed to berelatively limited in most EU countries at thetime the interviews were conducted. In mostcases structured products were the most popularCRT instruments. On the basis of theinformation provided, risk shedding usingcredit derivatives varies between 1% and 13%of total assets, while risk taking was up to 10%of total assets at individual institutions (seeTable 2). As regards the nature of creditderivatives, single-name instruments wereclearly the most used.

The major intermediary banks were reported tobe active in market making and trading in creditderivatives. Intermediary banks also use theseinstruments to hedge CDO positions and tocreate synthetic CDOs. These institutions are

Protection buying Protection selling Number of institutions% of total assets % of total assets surveyed

Germany1) 7.8% credit derivatives 8.7% credit derivatives 10

Greece 0.02% 0.2% 3

Spain 3-15% structured products n.a. 4

France2) 0.6-12.9% credit derivatives 0.3-9.6% credit derivatives, 30.2-1.5% structured products 0.1-8.5% structured products

Ireland 0.13-4% credit derivatives 0.6-7% credit derivatives Protection buying: 61-10% structured products 0.2-0.6% structured products Protection selling: 9

Italy 0.5-5% credit derivatives 0.1-5% credit derivatives 40-6.5% structured products 0.2-7.5% structured products

Luxembourg 0.5% credit derivatives 1.7% credit derivatives Estimate for the entire national0.5-1% structured products 1.5-2.5% structured products banking sector

Austria 0.7% credit derivatives 3.4% 8

Portugal 5-30% structured products 2-3% credit derivatives 4

Table 2 Protection buying and sel l ing by individual banks according to the survey

1) Protection buying and selling reported as an average of the ten surveyed banks.2) Data as at end-June 2003.

9 See also the reports by FitchRatings and Standard & Poor’s.

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3 BANKS’INVOLVEMENT

IN CRTresident mainly in Germany, France and UnitedKingdom.10 Some banks in Italy and Irelandalso reported relatively large-scale use of creditderivatives (mainly for portfolio managementpurposes) as measured against total assets ofinterviewed banks in the respective countries.There were reports of increased interest in theseinstruments, which suggests continued growthin credit derivatives markets.

STRUCTURED PRODUCTSAmong the surveyed banks, risk shedding viastructured products reached as high as 30% oftotal assets (see Table 2), while risk takingvaried up to 9% of total assets. According to theinterview reports, banks’ involvement in theseinstruments (specifically their ownsecuritisations), correlates negatively with theirinvolvement in credit derivatives, with theexception of some French (protection selling)and Italian banks, which had fairly strongpositions in both. In Germany, securitisationwas reported to be much smaller in relation tototal assets than in the other countries.

On the basis of the latest developments, itseems probable that structured products willcontinue to play an important role in the CRTactivities of EU banks, including regionalbanks.11 A significant factor facilitating banks’structured product business has been theenhanced market liquidity.

UNDERLYING ASSETSIn the case of credit derivatives, the underlyingassets were usually reported to be loans(including credit lines) and bonds issued byfirms (both financial and non-financial), thepublic sector or even sovereign governments.This applied to both protection buying andselling. In structured securitisation deals, theunderlying assets were mainly mortgage,consumer and corporate loans (sometimesSME) as well as credit card or leasingreceivables.12

The quality of underlying assets is one of thekey ingredients in assessing the amount of risktransfer. It is commonly perceived that trading

in CDSs (and CDOs) involves mainly high-quality assets,13 whereas lower-quality CDSsand tranches of structured products aretypically held by banks, but often temporarily,before being sold to investors such as lifeinsurance companies or hedge funds.

The surveyed banks provided some data on thequality of underlying assets, particularly incredit derivatives. These were largely reportedto be investment grade, often very highly rated,especially in protection selling. In the surveyedFrench banks, investment grade underlyingassets in derivatives varied between 68% and88% for protection bought and between 86%and 96% for protection sold (AAA/AA rated:12-40%). The German banks said thatapproximately 75% of underlying assets forprotection sold and 72% for protection boughtwere investment grade (AAA/AA: 22-26%).Figures were also available for two Italianbanks, which reported that approximately 85%of all credit derivative activity was based oninvestment grade assets (AAA/AA: 65%).

Taking CRT activity as a whole, clearly only asmall part involves assets rated BB or below,14

or non-rated SMEs15 and non-performing loans.It should be noted that securitisation of non-performing and doubtful assets is not allowedin some EU countries (e.g. Portugal).

10 See also “Global Credit Derivatives: Risk Management orRisk?”, FitchRatings, March 2003; “Global Credit Derivatives:A Qualified Success”, FitchRatings, September 2003; and“Demystifying Banks’ Use of Credit Derivatives”, Standard &Poor’s, December 2003.

11 In many countries, conventional guarantees and loan sales arealso important. However, these are outside the scope of thisstudy.

12 In particular, small and medium-sized banks used mortgage loansand credit card receivables in their securitisation deals.

13 Approximately 90% of assets underlying CDSs are investmentgrade, according to Standard & Poor’s. See “DemystifyingBanks’ Use of Credit Derivatives”, December 2003.

14 Some survey responses indicated that assets rated BB and belowcounted for less than 10% in protection buying and selling in allinstruments. At interviewed German banks, for example, 6-8% ofall underlying assets were rated BB or below.

15 The maximum reported share was 20% of protection buying andselling.


3.3 NET PROTECTION BUYING OR SELLING?

With regard to net positions in protectionbuying and selling, the general notion is thatprotection against credit risk is bought bybanks, whereas other sectors, such asinsurance, act as sellers of protection.However, the issue of net CRT positions seemsto be far less clear in the case of banks than isgenerally thought. Protection buying is notnecessarily always optimal or feasible for abank. As discussed above, the choice of variousCRT instruments would seem to be betterexplained by national factors such as the size ofthe economy and the nature of the financialmarkets, as well as by a bank’s customer baseand the heterogeneity of its banking bookassets.

According to the interview reports, banks witha specialised or narrow customer base haveresorted to protection selling in order todiversify the credit risk in their banking book,particularly as the ability to originate CRTinstruments to shed risk can be quiteconstrained by the nature of a bank’s assets (forexample, non-rated SME loans). In the case ofbanks with a wider customer base and morewidespread activities (lending, assetmanagement, investment banking), versatilityhas enabled them to buy protection on one sidewhile selling it on the other. An additionalfactor contributing to the observed diversity ofCRT involvement is the novelty of theseinstruments.

The different structural factors and approachesadopted by banks are reflected in the mixedroles reported by most banks. Some said thatthey originated CRT instruments from their loanportfolio while at the same time taking on creditrisk with the aim of diversifying risk exposureor investing excess funds. In general, however,EU banks were found to be more active inprotection buying than in selling, mostlythrough their own securitisation transactions.

The majority of banks were reported to be netprotection buyers in 2003. Based on notional

amounts, these included banks from Belgium,Spain, Ireland (medium-sized banks), France,Italy, the Netherlands, Portugal and Sweden.Net protection sellers were large Irish banks16

and smaller regional German banks, as well assome Austrian, Danish, Greek and Luxembourgbanks, which generally had a relatively limitedinvolvement as measured by the ratio of CRTactivity to total assets.

Particular care should be taken when assessingnet positions using notional amounts of risktransferred. Banks may ultimately retain at leastpart of the first-loss tranche while transferringmore senior tranches to investors. The netimpact of these transactions on their balancesheets could well be an increase in credit risk(relative to balance sheet size) rather than areduction. Hence, computing banks’ netpositions in CRT from notional amounts canprovide only a rough estimate at best and maybe misleading at worst. Assessment of actualnet positions would require information on thenature of the assets underlying CRTinstruments and the risks transferred. Precisenetting is possible only with same or verysimilar entities, and banks often incur somedegree of basis risk in their hedgingarrangements.

In the case of banks mainly involved inportfolio management, net positions are likelyto be easier to compute, as most of theinstruments are held in the banking book forlonger periods. However, in the case ofintermediary banks, the issue is the degree towhich intermediary banks are hedged in theirtrading books, as also mentioned in theStandard & Poor’s report.17 This is not a simplething to measure given the very dynamic natureof CRT activities in these institutions.

16 Two out of the three large credit institutions interviewed reportedthat they sell protection in net terms as at end June 2003.

17 It was mentioned as an example in the Standard & Poor’s report(December 2003) that it is theoretically possible to have a longposition in one set of reference entities and a short position in acompletely different set, so that while the difference betweenthe amount of protection bought and sold is zero, the actualamount of the unhedged positions is the sum of the two.

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4 THE FUNCTIONINGOF CRT

MARKETS

4 T H E F UNC T I ON I NG O F C R T MARKE T S4.1 SECTOR AND GEOGRAPHICAL LOCATION OF

COUNTERPARTIES

CRT markets appear to have increasinglybecome a bank-to-bank market. The importanceof large, internationally active, intermediarybanks is clear, particularly in credit derivativesmarkets and in synthetic CDOs. According tothe interview reports, large intermediary banksare key counterparties in most credit derivativetransactions. In some countries, the proportionof universal banks as counterparties was veryhigh, even 80% (Germany). Securities houses,investment firms and hedge funds were alsorelatively important (10-30%). Some banks alsomentioned non-financial firms, in line withsome of the market reports.18 According tointerview reports, the share of insurancecompanies varied between 1 and 10%.

Even though on the whole a relatively smallshare of trading in credit derivatives wasreported to take place across sectors owing tothe importance of large intermediary banks, theactual amount of credit risk transferred isdifficult to estimate. It is useful to look atavailable market reports to obtain a view of theoverall size of the markets. In those reports theassessment of the credit derivatives market inthe latter half of 2003 varied between USD 3trillion (notional amount of credit derivativesoutstanding according to Standard & Poor’s19)and USD 1.7 trillion (gross protection soldaccording to FitchRatings20).

The assessments of the net risk transfer activityby banks to other sectors using creditderivatives (as defined in the respectivereports) vary between USD 100 billion(Standard & Poor’s) and USD 230 billion(FitchRatings). This would indicate that theactual net risk transfer from the banking sectorto other sectors is quite small relative to thetotal trading volume, and is consistent with thebank interviews conducted for this report.

According to the interviewed banks, someinsurance companies (in particular general andreinsurance companies) reduced their

involvement in CRT markets towards end-2003.It was also reported that owing to higherfunding costs, CDO tranches rated AAAbecame less attractive for some banks andinsurers. However, even if there was somepulling back, the insurance sector was still asignificant counterparty in protection selling,owing to its existing investments. 21 Accordingto the FitchRatings’ report of September 2003,the largest net seller of credit protection was theglobal insurance industry (includingmonolines) with a net protection sellingposition of USD 303 billion in creditderivatives. Excluding monoline insurers, netinvestments in credit derivatives of theinsurance industry amounted to USD 137billion.

Monoline insurance companies (or financialguarantors) were reportedly majorcounterparties for investors in CDOs throughtheir “wrapping”22 of senior tranches,especially because of the volume of outstandingobligations. They were also consideredimportant counterparties for protection buyersvia synthetic CDOs.23 Conscious of the tightscrutiny of their asset quality by ratingagencies, the appetite of monolines hasreportedly moved towards more highly ratedrisks.24

18 See for example “Demystifying Banks’ Use of CreditDerivatives”, Standard & Poor’s, December 2003.

19 See “Demystifying Banks’ Use of Credit Derivatives”, Standard& Poor’s, December 2003.

20 See “Global Credit Derivatives: A Qualified Success”,FitchRatings, September 2003.

21 Some interview reports mentioned that specific insurancecompanies have invested in higher risk equity and mezzaninetranches (they do not usually invest in CDSs). Life insurancecompanies, for example, may use CDO tranches as collateral forretail policies, in preference to traditional credit investments.Insurance companies and asset managers invest in (funded)CLNs, typically on an accrual rather than mark-to-marked basis,which permits losses to remain unrecognised.

22 Credit wrapping involves the provision of a financial guaranteeof the obligations of the underlying issuer. The guarantee itself isan unconditional and irrevocable guarantee of principal andinterest on a security.

23 According to the FitchRatings’ report (September 2003), ten keymonolines had wrapped USD 56 billion of cash-funded CDOs. Inaddition they had sold protection in the amount of USD 166 billionvia synthetic CDOs.

24 See also FitchRatings, September 2003.


Hedge funds were reported to be increasinglytaking on credit risk, including first-losstranches. Hedge funds’ use of CRT marketswas originally motivated mainly by convertiblearbitrage, but more recently other strategieshave involved the use of CRT instruments. Inparticular, long/short strategies werementioned. Typically, hedge funds’ take longpositions in the bond market (which alsoprovides them with collateral) and take shortpositions in CDSs. This strategy is necessitatedby the still underdeveloped state of the repomarkets in corporate bonds.

Cross-border activities were reported to bevery high in CRT activities, usually between80-100% with only few exceptions. However,usually in the case of products involving non-rated firms, counterparties were reported to bedomestic as these instruments requireknowledge of local firms. In terms of a locationof counterparties in credit derivatives forprotection buying and selling, banks located inUS and EU clearly had a strong role. AlsoSwitzerland, Australia (protection sold) andsome emerging markets (protection sold) werementioned but to a lesser extent. London and toa lesser extent New York were specificallymentioned as cities where many of thecounterparties reside for CRT activities.

4.2 MARKET CONCENTRATION

As noted, concentration seemed to be an issueparticularly in the novel instruments (creditderivatives and CDOs), where largeinternationally active banks were reported tohave a central role. Typically, it was reportedthat banks involved in portfolio management viacredit derivatives and structured instrumentshad a direct relationship with intermediarybanks. As the very largest intermediarycounterparties number about five to ten US,Swiss and EU names, some “tiering” wouldseem to be observable at the global level. Theconcentration of counterparty dealings may befurther amplified by the fact that the institutionsacting as the largest counterparties in the CRT

area play a similar role in the more traditionalderivatives markets (e.g. OTC interest rate andcurrency swaps).

As regards potential changes in the future, mostbanks held the view that the degree ofconcentration in CRT business will decreaseowing to growing liquidity and a broader rangeof counterparties (such as hedge funds) andreference obligors in the market. However,opposite opinions were also expressed, basedon the notion that the financial sector as a wholewill continue to experience concentration andconsolidation in the future.

4.3 POTENTIAL PROBLEMS RELATED TO MARKETSTRUCTURE

DEFAULT OR EXIT OF A MAJOR COUNTERPARTYBANKWith regard to the question of what couldconstitute a major shock to the smoothfunctioning of CRT markets, the answers variedsomewhat. However, the majority of banksthought that the default of a major counterpartycould cause difficulties. It is important to notethat the exit or default of a major counterpartywas seen as a risk to the functioning of themarket as a whole rather than to the stability ofthe individual institution, as most banksgenerally thought that that they were adequatelymanaging their own counterparty risk.

If a major counterparty were to discontinue itsCRT business, the banks generally envisagedonly a short-term impact. However, the severityof the short-term market unrest was seen todepend strongly on the reasons for the exit andwhether they were orderly or not. If a majorcounterparty were forced to leave the marketbecause of massive losses or bad riskmanagement practices, this might cause majordisturbances. The situation in the CRT marketscould worsen particularly if the exit was seento have systemic implications, as similarinstitutions might suffer from contagion, i.e.general distrust in the markets. The situationwould clearly be less severe if the exit of a

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4 THE FUNCTIONINGOF CRT

MARKETScounterparty were due to strategic reasons. Inthis case, short-term liquidity could be affected,although in the medium-term these effectswould disappear. However, banks questionedwhether a failure of one dominant player couldreally induce a widespread systemic problem, asnet exposure of these large intermediaries isusually relatively limited.

Banks expressed some worry that experiencesrelated to, in particular, Argentina, WorldComand Enron defaults could drive the insurancesector to reduce significantly its presence in theCRT markets. It was also indicated thatmonoline insurers might withdraw to somedegree from CRT markets because of changes inaccounting rules. With regard to the exit of aninsurance company active in CRT, views variedas to how serious an impact this would have.Taking into account that the insurance sector isa clear risk-taker in CRT markets, the exit ofsuch counterparties could reduce the supply ofprotection against credit risk to a certain extentand increase concentration further among thebig internationally active banks involved intrading in CRT instruments. On the other hand,the arrival of other counterparties to supplyprotection in the CRT markets – such as hedgefunds – could quickly fill the void if insurancecompanies continued to leave.

ADDITIONAL PROBLEMS CAUSED BY THE LIMITEDNUMBER OF MAJOR PLAYERSIn general, banks viewed the CRT markets asfunctioning properly. However, severalproblems were mentioned that could result fromthe limited number of players. Among otherthings, it was mentioned that the small numberof players could result in prices not fullyreflecting the underlying risk, as the marketmechanism may function imperfectly becausethere are few opportunities for arbitrage. Thisproblem could be partly mitigated by productstandardisation.

Despite the generally improved liquidity, it wasnonetheless thought still unsatisfactory in somesmaller market segments. This could beimproved by increased market making by the

existing intermediary banks. However, marketmaking among only a few key counterpartiescan create a “false sense of liquidity”, as highconcentration can render markets morevulnerable to market exits.

On the protection selling side, concentrationamong monoline counterparties was consideredhigh by some banks. Partly in relation to thereported opaqueness of the information oninsurance counterparties, banks expressed theview that it was not clear where the losses fromthe three major credit events to date – namelythose relating to Argentina, WorldCom andEnron – had ended. Some banks thought itpossible that they were concentrated in on andoff-balance sheet positions of counterpartiesthat had not yet revealed them. To resolve thisproblem, it may be desirable to improve thedisclosure of actual consolidated exposures byfinancial intermediaries.

OTHER POTENTIAL PROBLEMSMany interviewed banks also questionedwhether the institutions involved trulyunderstood and recognised the risks they weretaking on. In particular, the opaque pricing andrisk characteristics of structured products, suchas CDOs, were mentioned in this respect. Asubstantial involvement of insufficientlysophisticated institutions could make the CRTmarkets prone to event risk, thus reducing itsattractiveness.

The differences in capital or transparency ofinformation requirements between the insurancesector, hedge fund and banking sectors werealso highlighted. In addition some banks saidthey were worried about the opacity of thefinancial reporting of monoline companies,because it is difficult for banks to assess theirexposure to these counterparties.

Many banks feared that changes in currentlegal, tax or regulatory conditions could havean adverse impact on the business. Some fearedspecifically that legislators might decide toconsider CRT products as insurance productsand that they should be treated as such for


accounting and tax purposes. Disputes onexisting legislation and standards could alsoconstitute a problem.

Some banks raised as a major worry thepossibility of mispricing as a result of banksengaging in CRT for regulatory arbitrage ratherthan credit risk management. It was also fearedthat mispricing could arise from aggressivepricing of CRT instruments by smallerinstitutions trying to increase their share in thehighly concentrated CRT markets. This wouldhamper an efficient reallocation of credit risksvia the CRT markets. It was mentioned,however, that the upcoming New Basel CapitalAccord (Basel II), which introduces risk-sensitive capital requirements, would likelyimprove the pricing of credit risk, as it wouldreduce the difference between regulatory andeconomic capital.

4.4 LIMITATIONS TO THE USE OF CRT MARKETS

As expressed by banks, limitations to the use ofCRTs are usually connected with a small loanbook size (limited number of corporatecustomers suitable for risk mitigation via CRTinstruments) judged on an international scaleand high transaction costs compared withalternative funding sources. It was alsomentioned by some banks that the spread earnedon loans at the time of the interviews was notsufficient to cover the transaction costs.

Limitations to the use of, for example, singlename CDSs can also come from the nature of abank’s customer base. The average corporatecredit portfolio size of small and medium-sizedbanks, the lack of external ratings and activelytraded corporate bonds can be a problem. Inaddition, lack of liquidity in the secondary bondmarkets as well as in asset and mortgage-backedbonds can hinder growth in these instruments.In countries where this is a problem, the maincredit risks have traditionally been hedged byselling the loans or by using guarantees andcredit insurance. In some cases, this has been

supported by a strong role for specialisedfinancing companies owned by the government.

In some EU countries outside the euro area,limitations can also relate to a lack ofinstruments in national currency, as availablecredit derivatives are normally quoted in majorcurrencies.

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5 CRT RISKSAND RISK

MANAGEMENT

Box 2

RISKS IN CRT INSTRUMENTS

The identified risks, which differ in some cases according to the CRT role concerned (i.e.portfolio management and intermediation), or type of instruments used, are as follows:

Credit risk refers to credit exposures. It may refer to an outright exposure (e.g. incurredthrough protection selling), to a first-loss position (e.g. incurred through securitisation withrecourse to the originating bank) or to the need to dynamically hedge an exposure (e.g. incurredthrough delta hedging of protection sold by an intermediary bank). For a bank acting as CRTinvestor, the credit risk assumed via CRT instruments is held on the banking book, often untilmaturity. This bears a close resemblance to traditional lending activities and is often managedaccordingly. However, an intermediary has to dynamically hedge its positions whilemaintaining a consolidated view of credit risk in both its banking and trading books.

Model and pricing risks refer to potential errors made in modelling and pricing the exposuresarising from a loan portfolio, e.g. in assumptions about correlation between reference entitiesand modelling of embedded options in structured products.

Liquidity risk refers to market liquidity and the potential inability to execute CRT transactionsover a short time period in the desired size. Desire for liquidity could include the following, forexample: protection sellers reducing exposures following some company news; intermediariesadjusting hedges following a large price movement; investors in a CDO tranche wishing to sellthe asset; and originators of securitisations seeking a funding source.

Counterparty risk refers to credit exposure to counterparties in derivative or structured producttransactions if they fail to honour their obligations. Counterparty risks may be mitigated bynetting arrangements or collateral supplied under credit support agreements (CSAs).

Counterparty correlation risk refers to the possibility of a correlated deterioration in the creditstanding of a counterparty and the underlying reference entity; or, where applicable, to acorrelation between counterparty, reference entity and collateral.

Basis risk refers to the possibility of loss from imperfectly matched risk positions in two relatedmarkets. Examples include exposure to a loss from a maturity mismatch caused by a change inthe shape of the yield curve and the variability of returns stemming from possible changes in thepricing basis or the spread between two rates or indexes.

Legal and documentation risks refer to the risk that CRT contracts may not prove legally robust,i.e. that one party’s (notably, the protection buyer’s) understanding of the contractual

5.1 SOURCES OF RISK

In discussions with the banks surveyed, a wide-ranging set of sources of risk was identified(see Box 2). Not only the risks mentioned byeach bank but also the order in which they were

5 CRT R I S K S AND R I S K MANAGEMENTranked varied in the survey according to theCRT role concerned (portfolio management orintermediation) and according to the productsinvolved. Particular risks were mentioned in thecase of structured products.


arrangements could be overturned by a court challenge. A concern, which arises particularly forintermediaries, is settlement risk arising from differing or incomplete confirmations oftransactions.

Systemic market disruption risk refers to the potential for major disruptions e.g. in marketmaking and price quoting, or in the availability of credit protection.

Reputation risk refers to the risk that banks may undertake transactions at a substantial loss,despite no contractual obligation to do so, in order to maintain their good reputation.

Rating risk refers to the risk that, first, underlying entities and counterparties may, as a whole,prove to be less creditworthy than implied by ratings; and, second, that structured products suchas traditional securitisations and CDOs may prove to be less creditworthy, perhaps because ofmistaken correlation assumptions in the rating process.

Regulatory risk refers to the risk of adverse changes that would disrupt business practices beingintroduced by rule and standard-setters, such as supervisors and regulators (and, interpretedbroadly, accounting standards bodies).

In portfolio management, protection sellersranked credit risk and model (includingpricing) risks as serious concerns, and to alesser extent, liquidity risk (the inability tohedge instruments when necessary to adjustrisk profiles).

Protection buyers were above all concernedabout counterparty risk. Indeed, a number ofportfolio management banks listed this riskamong the key risks, even though it has beenmitigated, according to many interviewedbanks, partly owing to tight selection ofcounterparties as well as collateral requirementsand netting.25 However, as many banks stillreport it to be important, it is likely that riskmitigants are not used to the fullest extent by allbanks. The relevance of this risk also seemed tovary depending on the instruments in whichbanks were mostly involved. Finally,correlation risk between reference entities,counterparties and collateral was consideredsignificant in protection buying. A doubledefault of a major underlying firm andcounterparty was considered to constitute asevere shock scenario, with larger associatedlosses than in correlated events in otherderivative markets.

In intermediation, the major concerns werecredit risk (which may have to be dynamicallyhedged), liquidity risk, and model (includingpricing) risks. Correlation risk betweenreference entities, counterparties, and collateralis also an important concern on the protectionbuying side.

Counterparty risk figures relatively low amongintermediaries’ concerns, because of theextensive use of collateral and nettingagreements. Banks often mentioned thecounterparty risk exposure to monolines, bothdirectly as counterparties, and indirectlybecause of “wrapped” (guaranteed) CDOs thatintermediaries have arranged.

Legal and documentation risks were mentionedby many banks, largely irrespective of theiractivities in CRT markets. With regard to theseverity of these risks, there was very littleevidence of legal disputes regarding CRT.Banks reported however that, althoughInternational Swaps and DerivativesAssociation (ISDA) documentation had so far

25 There were reports that collateral can reduce the derivativescounterparty credit risk by almost 50%.

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5 CRT RISKSAND RISK

MANAGEMENTworked well, contracts under ISDA have notbeen seriously legally challenged as yet. Hence,it would seem that banks were worried about theuncertainty about the legal strength of thesecontracts in future rather than existing legalproblems. In particular, multiple jurisdictionsand non-harmonised regulatory treatmentacross countries were seen to be problematic. Aminor concern was the possibility of settlementbacklogs because confirmations (oftransactions) have not kept pace with marketinnovation.

As regards individual institutions’ attempts tomitigate the legal risks, banks reported that theyused call options in their CRT contracts orsought advice from external consultants. Therehave also been wider attempts to improve thecontractual framework for CRT instruments, inwhich significant progress has already beenachieved.

RISKS RELATED TO STRUCTURED PRODUCTSIn structured products, interviewed banks thatsell protection in CDOs were concerned aboutmodel (including pricing) risk, rating risk andlack of transparency in complex products(especially in synthetic CDOs). Model andpricing risks were seen to be potentially verysevere, since they may discourage banks frominvesting in, particularly, non-standardisedCRT products. This could hinder the wideningand deepening of some market segments andhence result in low liquidity. An additionalconcern was mentioned to be the lack ofliquidity, which may force an investor to buyand hold. As regards rating agencies, exclusivereliance on assessments prepared by theseinstitutions in the case of structured productswas mentioned as a risk by some banks. Ratingagencies may also have a strong indirect impacton structured product markets via the ratingsthey give to monoline companies.26 Owing tothe nature of monoline companies’ business, adowngrading from a status of AAA could haveserious consequences for the ability of thesecompanies to conduct business.

For protection buyers, a major concern wasreported to be reputation risk, i.e. the risk thatthe underlying assets may not perform well,inducing non-contractual efforts to recover thelosses. Broader risks mentioned includedliquidity risks (the loss of a funding source) andregulatory risk in the case of origination. Bankswere worried about regulatory changes,particularly when origination is driven bymotivations other than risk shedding anddiversification, such as funding needs. Thesemotivations may also result in increased creditrisk. For example, banks often retain at leastpart of the first-loss tranches of the structuresoriginated by them. Regulators have respondedto this by requiring a 100% regulatory capitalcharge on the retained tranches.27

Pricing and modelling risks were seen to beespecially relevant in intermediation. The scopefor these risks was considered to increase whenis the model is driven by only a small amount ofinformation on asset pools or on the keyparameters. In addition, many banks considereda problem the lack of information on the numberand the level of sophistication of end investors.

5.2 RISK MANAGEMENT

According to the banks surveyed, changesimplemented in bank risk management systemsare associated with the level of involvement inCRT markets – more sophisticated CRTproducts and trading strategies havenecessitated enhancements in risk modellingand information technology infrastructure.Major banks involved in intermediation of CRTinstruments have already implementedsignificant changes to their risk managementsystems to accommodate active trading in theseinstruments. For the more active banks, riskmanagement infrastructure improvements were

26 For additional discussion, see “Credit Risk Transfer”, CGFS,December 2002.

27 See Kiff J., Michaud F-L. and Mitchell J. “An Analytical Reviewof Credit Risk Transfer Instruments”, Banque de FranceFinancial Stability Review No. 2, June 2003 and National Bank ofBelgium Financial Stability Review 2003.


stimulated by the recent economic slowdownand the possible losses from CRT instruments.However, most EU banks that are involvedmainly in portfolio management have not seenit necessary to modify their systems, since theirinvolvement in the CRT markets is smaller.

It should be noted that while banks aregenerally confident about adequacy of their ownrisk management practices, some of themexpressed concern about other banks’ as well asother financial institutions’ ability to managethe risks in CRT instruments. Some wereworried about smaller market players,specifically in structured products. The concernwas whether involved parties really understoodthe amount and the type of risk they werebuying from the market. As regards financialinstitutions other than banks, some concernswere expressed about the potentially low levelof risk management sophistication at insurancecompanies.

PORTFOLIO MANAGEMENT BANKSSmall and medium-sized European banksreported that they operate cautiously in newmarkets, not engaging in new activities beforerisk management systems are able to cope withthem. Some banks reported that the decision toengage in CRT instruments had to pass throughthe filter of several committees, composed of allrelevant departments. Training of staff involvedin the CRT business was seen to be a highpriority and a key factor for success by mostbanks.

After the reported cautious first steps, mostbanks were confident that limited CRT activitycould be handled within their existing riskmanagement framework. Most portfoliomanagement banks said they did not have anyspecific framework for managing risks relatedto CRT instruments. They used their existingrisk management systems on the grounds thatall the actions taken as part of internal controlmeasures used in other market activities alsoapplied to the various CRT instruments (volumelimits, assessment of the quality of thecounterparty as well as open positions,

maturities, size of the operation etc.) Tocomplement the analysis, market data werereported to be actively used. Banks which arenot active market-makers try to mitigate risksrelated to double defaults by carefully selectingcounterparties, by using the existingcounterparty limit systems on these trades, orby not engaging in trades where a doubledefault could become a concern.

A non-consolidated credit risk managementapproach was reported to be usually used,particularly if the use of CRT instruments wasconsidered marginal to total activities.However, as the relative importance of theseactivities has increased, demand has reportedlygrown for a more group and business area-widerisk management infrastructure. This was alsodeemed necessary to calculate economic capitalneeds in view of the implementation of Basel IIand requires specially trained staff.

The generally increased sophistication of thelatest credit risk models was mentioned as abenefit to CRT risk management. For example,banks reported that they had sophisticatedsystems in place already or that they were in theprocess of improving their credit riskmanagement systems at the time of theinterviews. While these improvements helpCRT activities, credit risk arbitrage and thedeepening of credit derivatives markets haveimproved the pricing of risks involved intraditional loan portfolios, hence contributingto a better management of overall credit risks.

INTERMEDIARY BANKSIntermediary banks said they use high qualityinformation technology for pricing, valuationand monitoring of the credit risk in their CRTbusinesses. There are a number of specific risksrelated to intermediation activities that requirecareful management (see above). Owing to highvolumes, banks reported that it has beennecessary to put in place sophisticated tools formanaging specific aspects of these risks.

The banks said they mitigate the risk related tohigh correlation between the borrower/obligor

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MANAGEMENTand the protection writer (guarantor) by meansof collateral agreements, executing trades on afunded basis and restricting transactions on thebasis of correlation modelling. Relatively lowlevels of correlation risk are mitigated bytrading (buying or selling) broad indices astranched securities. CDOs and the associateddelta hedging give rise to special risks of atechnical character:28 (i) on residual equity,which typically requires hedging at a largedelta, and therefore gives rise to liquidity risk;and (ii) on senior tranches, where the risk isprice gapping i.e., discontinuous pricemovements that cannot be covered by deltahedging. As regards technical risks related toCDOs, banks responded that they have put intoplace sophisticated risk management systemsbased on enhanced risk models. They also use anumber of other tools, such as credit risk limitswhich are marked-to-market daily,consolidation of credit risk positions acrossbusiness lines, correlation estimates based onstressed market conditions and strengthenedinternal credit allocation processes.

By and large, credit risk management in majorintermediary banks appears to have improvedgreatly over recent years. However, theinnovative evolution of the market does meanthat new kinds of risk can appear, or old risksgain new prominence. The growth in single-tranche CDOs29 has highlighted the risks fromcorrelations, price jumps and reliance on marketliquidity for dynamic hedging. At the sametime, the growth in credit indices has providedan important tool to hedge bespoke CDOtranches created to meet demand fromcustomers. In addition, CDS indices haveproved helpful for not only hedging, but alsopricing of CDS books. Single name CDSscontinue to be important for hedging largeindividual exposures.

THE ROLE OF RATING AGENCIESThe interviewed banks suggested that thereliance on rating agencies was weaklyinversely related to the level of sophistication ofa bank. For banks that were large andinternationally active intermediaries with

highly developed pricing models, rating agencyinformation was used as complementaryinformation or a as “second opinion”,particularly when information on asset poolswas considered poor. Portfolio managementbanks also mentioned that they mainlycomplemented their own assessment with ratingagency as well as other external information.However, as the internal analysis tools ofsmaller banks are often less developed, a ratingagency view may have a large impact on theirdecisions regarding CRT. In the case ofstructured products, the role of rating agencieswas considered particularly important byportfolio management banks. However, here,too, banks reported that they usuallycomplemented rating agency assessments withdata from their own models. Overall, fullreliance on rating agencies was reported not tobe very common.

5.3 IMPACT ON BANKS’ LOAN LOSSES OVER THEBUSINESS CYCLE

According to available reports, most banksthought that CRT activity had affected theircredit losses over the latest credit cycle only to alimited extent. Some Austrian banks said thatthey had experienced few credit events relatedto CRT instruments because they had investedmainly in investment grade instruments. InGermany, only one bank considered CRTinstruments as having been an important factorduring the late 1990s, when banks weretransferring risk to more thinly capitalised orless regulated industries. Three banks claimed

28 A delta-hedge is a risk-offsetting position that matches themarket response of the base or underlying position over a narrowrange of price or rate changes. Because one side of the netposition has option characteristics, the position must be modifiedto maintain delta neutrality if the price or rate moves beyond anarrow range.

29 At a time of cyclical compression of credit spreads, majorintermediary banks have increasingly been retaining first-loss(equity) tranches of synthetic CDOs and also senior tranches(partly reflecting reduced activity by monoline insurancecompanies), giving rise to the “single-tranche” CDOs, purely asecond-loss or mezzanine tranche. Retained tranches are delta-hedged.


that loan loss provisions were avoided by theuse of CRT instruments. It should be noted thatactive protection selling by banks may alsocreate increased need for provisioning; in thecase of Germany, for example, there were somereports of this.

As regards the future impact of CRT on creditcycles, the banks’ views varied. However,many thought that CRT instruments would helpto optimise the relationship between assetquality and provisioning in the future.Therefore, there may be less need forprovisioning as CRT instruments help banks todiversify credit risk across economies withdivergent credit cycles. It was consideredpossible that by the time the credit cycle turnsagain, the number of players may have grownsufficiently to amplify the positive implicationsfor business cycles from CRT.

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FOR BANKS’STRATEGIES

According to the interview reports, drasticchanges in banks’ business models are yet to beseen. Most of the banks said they thought ofCRT as part of their existing strategy, relativelyeasily integrated into their present businessmodel, rather than as a means to do business ina new way. Within their main strategy, some,mainly intermediary banks, mentioned anexplicit business and risk strategy for CRT.

Deepening and widening of the CRT marketswere seen as potentially enabling banks to makemajor changes to their business strategies.According to a number of interview reports,CRT could make it possible for banks toseparate lending from customer relationship, asthey would be able to manage the amount ofcustomer-specific risk without limiting primarylending. This could also drive supply of newservices to customers. Constraints on a bank’sability to meet customer needs could hence beeffectively reduced. Initial signs of thesedevelopments were already visible in somebanks’ reports. Also, instruments such asCDOs were seen to allow certain risk areas tobe isolated and transferred in a way that wasimpossible a few years ago, allowing solutionsto be tailor-made for customers withparticularly specific requirements.

A more universal, consolidated approach tocredit risk assessment and management,involving no distinction between the variousinstruments used for taking on credit risks, wasalso foreseen. Pricing and management of creditrisk in its various forms would hence converge.Loan pricing was also seen as likely to becomemore transparent.

Easier access to diversification through the useof CRT products was seen to enable morespecialised banks to compete more effectivelywith banks that have a more diversifiedcustomer base. This will allow banks to focusmore and more on the activities in which theyhave a competitive advantage without having tobe concerned about the concentration of risks.CRT also enables banks to engage in larger loan

6 IMPL ICAT IONS OF CRT FOR BANKS ’ STRATEG IESand bond transactions without increasing creditrisk or lending capacity.

With banks’ risk pricing models improving, itwas considered possible that the nature oflending business might change in the nearfuture. Banks foresaw that they would be ableto choose more easily the size of the balancesheet they were able to hold. However, theysaid it was unlikely that banks could developinto purely fee-driven businesses, as this wasseen to be too risky. A relatively stable balancesheet-based income flow was expected toremain part of the business models of banks infuture. This view was supported by many banksthat saw themselves continuing with traditionalbanking business, as CRT would make it easierto optimise the risk-return of the banking bookwithout needing to resort to loan sales. It wasargued that lending could even be positivelyinfluenced, as the access to credit protectiongives more flexibility to commercialdevelopment.


The findings of the survey provide a basis foridentifying some new policy implications forthe authorities represented in the BankingSupervision Committee (BSC) as regards theuse of CRT instruments and they bring out newaspects of some implications previouslyidentified in international fora. This reflects theresponsibility of the authorities and theCommittee to monitor the evolution of banks’risks and, more generally, financial stabilityand to explore the responses that may be neededto maintain financial stability. The nature of theissues raised call for attention from supervisoryauthorities and central banks. However, they donot call for any specific regulatory response.This section summarises the issues for centralbanks and supervisory authorities arising fromthe survey. The issues are categorised undermacro-prudential and micro-prudentialoversight. Further work is also clearly neededin cooperation with securities and insurancesupervisors to complete the picture on CRTactivities and to evaluate the need for cross-sectoral supervisory responses. Indeed, work isalready underway in the EU framework.30

Finally, future accounting regulatory changesmay have an important impact, which will needto be assessed.

7.1 MACRO-PRUDENTIAL OVERSIGHT

SYSTEMIC MARKET DISRUPTIONSA few banks interviewed considered that asystemic market event is a potential, thoughunlikely, threat that might arise from the defaultof a major intermediary, a large credit eventleading to settlement difficulties, or a fraudleading to loss of confidence in the market.Additionally, legal, tax, or regulatory changescould undermine market confidence. Foractively trading banks, a useful way to assessrisks is to simulate scenarios of stress and theoperational and information issues that wouldarise.

The increased involvement of hedge funds,including convertible arbitrage and distresseddebt funds, as leveraged investors in the highest

7 PO L I C Y IMP L I C AT I ON Srisk spectrum of CRT instruments might raisesome concerns. Generally, hedge funds areimportant in providing liquidity to the marketand, therefore, are a positive influence onmarket efficiency and stability. They can alsoprovide an alternative to the views and modelsof more established market participants (such asrating agencies). Experience suggests,however, that their capacity for increasingleverage and the speed with which they maymove into and out of markets may lead toinstability, implying an inherent vulnerability.Additionally, hedge fund participation maymake the identification and resolution of a crisismore difficult.

The involvement of unregulated and possiblyopaque entities in a crisis could haveimplications in both an ex ante and an ex postsense. Their activities should ideally bemonitored, to the extent feasible. Before theonset of a crisis, the lack of supervisoryoversight of such institutions could mean that abuild up of financial vulnerability goes largelyunnoticed, exacerbating the magnitude of anycrisis. And, once signs of a crisis emerge, itmay be more difficult to establish all the factsneeded to effect an orderly resolution. Theinvolvement of unregulated entities thereforenecessitates continued close cooperationbetween supervisory authorities on crisisarrangements. From the financial stabilityperspective, the key importance of banks havingappropriate risk management vis-à-vis theirhedge fund exposures was made very clear bythe case of Long-Term Capital Management(LTCM).

COUNTERPARTY RISK AND CONCENTRATIONSMarket disruptions stemming from the failureof a major intermediary (at worst correlated

30 The BSC has already started close collaboration with the levelthree EU supervisory committees for securities and insurance –the Committee of European Securities Regulators (CESR) and theCommittee of European Insurance and Occupational PensionSupervisors (CEIOPS), respectively – to monitor CRT activity inEU and assess the policy implications.

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with the failure of a major underlying entity) arevery unlikely events. The banks surveyed saidthat concentration risk among intermediariesmattered primarily because of potential(systemic) market disruption, rather thanindividual counterparty exposure. The highlevel of concentration in trading in CRT andother derivative markets is recognised to be alatent danger. It can offset the basic benefits offinancial innovation, notably the spreading ofrisk more widely in the financial system. Forthese reasons, continuing attention should bepaid to the strength of market infrastructure, thecapacity of the market to quickly repair damageto itself and ways in which confidence could berestored if undermined.

The “comfortableness” banks expressed withindividual counterparty exposures was based oncollateral and netting arrangements. It isimportant, therefore, to maintain the integrity ofthe arrangements (e.g. documentation).

A different concern arises from exposure tomonoline insurers. In principle, exposure to thespecialist monolines is no different from otherexposures subject to special examination bysupervisors if warranted. In practice, theprominence of the monolines in the CDOmarket does raise the issue of the opacity oftheir financial reporting. Banks say that theyfind it difficult to quantify their true exposure tomonolines. Insurance supervisors are aware ofthese issues, and may seek to collect moreinformation on monolines as they judgeappropriate.

NET TRANSFER OF RISKSome techniques of credit risk transfer (i.e.securitisation, syndication, guarantees) havealready existed for a long time and have becomea regular part of banking activity. The noveltechniques covered in this report are morecomplex and opaque, involve new players suchas those mentioned above and have a very highgrowth rate, which are the main reasons theyhave attracted the attention of authorities.

Most banks interviewed reported that their CRTactivities had not, by late 2003, made muchdifference to their loss experience. In someindividual cases, however, the positive ornegative influence of CRT activities on thebank’s loss experience had been notable. Insome cases, the reason for the minimaldifference is simply the small scale of activity.However, the use of CRT instruments couldalso reflect structural market features ratherthan the need to hedge or diversify risks. Mostimportantly, funding needs can be the mainmotivation for traditional securitisationtransactions (ABSs). The actual net risktransfer is reduced when banks retain the first-loss positions in structured products or whenthey buy protection on investment grade credit.This should also mitigate concerns that bankscould cease to monitor the asset quality ofcustomers subject to CRT (i.e. moral hazard).At any rate, information on the actual nature ofthe risk transfer is important as it complementsinformation inferred from banks’ monitoringactivities.

As a result of all these factors, there appears tobe a relatively low degree of actual net risktransfer. To assess the potential risks innational banking sectors requires ongoingmonitoring of the structural issues and actualunderlying motivations for the use of CRT bybanks. In addition, the degree of risk transfershould not be prejudged, but rather the specificsof particular transactions examined. One way ofreconciling CRT data sources would be furtherto investigate cross-sectoral net risk transfers.

The survey indicated that some banks can besignificant risk takers in CRT markets. Theeconomic case for this can be sound. Inparticular, these markets allow them to invest inassets which improve credit portfoliodiversification. However, a note of caution iswarranted, since a positive outcome relies onthe transactions being well conducted; i.e. thatcorrelation analysis, pricing of instruments andrisk management are sound. The databases andmethodological tools needed in this area stillseem to be under development.


SETTLEMENT AND DOCUMENTATIONSome concerns have been expressed among EUbanks over documentation and settlementissues. One concern is that documentation(including ISDA-type contracts and guaranteeinstruments of an insurance industry character)has not been subject to robust tests in the courts(though it is conceded that they have beensubject to market tests). In the trading markets,concerns appear to centre on settlement and itsability to keep pace with market development,as evidenced by the time (days or weeks) ittakes to agree confirmations of transactions.Additionally, there has been a continuingconcern over restructuring of debt and thedefinition of a credit event. “Modified-modified” restructuring (in the Europeanmarket) and “modified” restructuring (in theNorth American market) have sought to limitthe maturity of the deliverable obligation and tomake it a transferable or conditionallytransferable obligation. The issue bears furtherwatching to determine whether these concernsshould be considered merely “teething”problems of a new market, or whether theyindicate deeper structural problems.

TRANSPARENCY AND DISCLOSUREThough CRT instruments potentially improveefficiency in financial markets, a major problemat present is the opacity of CRT market.Consequently, transparency and disclosurecontinue to be important areas for improvement.There are four areas in which improvementscould be made:

(i) pre- and post-transaction disclosure toinvestors in CRT instruments about therisk characteristics of the specifictransactions;

(ii) public disclosures of CRT activities byindividual institutions, which would helpother market participants to assesscounterparty risk and enhance marketdiscipline;

(iii) compilation of statistics in aggregatedform, e.g. through the Bank for

International Settlements (BIS) semi-annual derivatives survey, which couldhelp to assess systemic market risks; and

(iv) incorporation of CRT transactionexposures, as well as the variousassociated mitigating measures used, intoconsolidated credit risk positions, so as tohelp supervisors to assess economicexposures more precisely than may bepossible from standard accounting andreporting requirements.

As regards the first issue, the survey points to aconcern that some banks and other marketparticipants might not have an adequateunderstanding of the full risks they engage in,especially as regards the most complextransactions. The increasing complexity of theinstruments (e.g. CDOs of CDOs, creditindices, correlation trading) can significantlyincrease the opacity of the information on theunderlying assets and institutions’ riskpositions. However, the survey results do notshed much light on whether this is due to thesupply of or demand for information being toolimited. Hence, supervisors might wish to focusmore on the adequacy of the information onwhich the investment decisions are made.

The second and third issues have beendiscussed in a variety of official circles.31 Thegeneral attitude of banks towards furthersharing of information was found to be positivein the survey. They also stressed the mutualbenefits of providing more information toauthorities and other financial institutions. Thefourth issue of supervisory information isdiscussed under micro-prudential oversightbelow.

31 Besides varying degrees of disclosure in individual bankaccounts, the one established channel of regular public reportingon credit derivatives is the Office of the Comptroller of theCurrency (OCC) quarterly report in the United States, whichcovers a number of major European banks.

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7.2 MICRO-PRUDENTIAL OVERSIGHT

The present work finds that banks use CRT in agreat variety of ways – ranging from activetrading to traditional securitisation and small-scale protection buying – and have acommensurate variety of risk managementsystems. The innovative and dynamicallyevolving nature of the CRT markets (includingthe increased participation of hedge funds)suggests that supervisors will continue to givesome priority to monitoring banks’ use of CRTinstruments. In EU countries where the overallscale of CRT activity remains low, however, thepriority will not be high and attention will befocused on specific banks.

Over the longer run trends in banks’ businessstrategies warrant monitoring, notably theimplications for incentives to monitor debtors,which may be weakened for the initial lender tothe extent that it has bought protection. Market-based pricing of credit risk and possible effectson competition and consolidation in thefinancial sector should also be watched. Issuesof regulatory oversight of CRT, includingdifferences in regulatory arrangements acrosscountries and sectors, are currently beingexamined at the international level.

SUPERVISORY INFORMATIONOne area where progress has varied acrossbanks is in the incorporation of CRT exposuresinto consolidated credit risk positions, so as tohelp assess economic exposures more preciselythan may be possible from standard accountingand reporting requirements.

Especially in the credit derivatives market, caremust be taken in interpreting the variousaccounting measures of CRT activity. Notionalgross amounts outstanding may be a misleadingguide to underlying risks without additionalinformation. For example, an assessment ofcounterparty exposures requires information onthe use of collateral and netting. The surveyedmarket participants suggest that an alternativemeasure of positions might be premiums paid

and received. Mark-to-market values may bemore a measure of activity and balance sheetsize than of risk. It is possible for perfectlyoffsetting economic positions not to beoffsetting on mark-to-market values; indeed,the mark-to-market values could be of the samesign (both positive or both negative). Analternative measure of portfolio risk exposure isthe sensitivity to movements in credit spreadse.g. the portfolio delta on a five-year equivalentbasis, which is the industry standard.Ultimately, measures of credit risk transferneed to be accurate and meaningful, and to beincorporated in an overall credit position. Somebanks – probably the most active trading banks– will have this information readily available.For some other banks, supervisors may need tocontinue to press for it.

RISKS AND RISK MANAGEMENTThe innovative character of the CRT market andthe complexity of the instruments point to theimportant principle that the sophistication of abank’s risk management goes hand-in-handwith the sophistication of the instruments that itemploys. The interviews carried out with banksindicate that risk management systems varyconsiderably within each of the groups(intermediaries or portfolio managers),suggesting that banks ought to be comparedwith the best practice of their peers.

The character of the market suggests that therewill be an ongoing concern with “naïve players”entering particular market segments. Forinstance, there have been a small number ofEuropean insurance companies that bought theriskier tranches of CDOs, suffered significantlosses, and withdrew from the market. Itappears that some of these risky products wereheavily marketed. In itself that marketing is nota concern, but it does raise the issue ofprotecting less sophisticated investors, whomay need to improve their knowledge of therisks. Monitoring and oversight are warranted,therefore, in respect of the degree ofunderstanding of novel risks. Minor mispricingof risk is perhaps a matter for market


32 In this context, regulatory arbitrage is used in the wider sense ofarbitrage between sectors (banking, securities and insurance),as distinct from the narrower sense of arbitrage across businesslines.

participants to remedy rather than a regulatoryconcern; mispricing becomes a concern if it islarge and systematic.

In CDOs, it is possible that some investors failto appreciate that jump-to-default risk(discontinuous price movements, contrary tomodel assumptions) may be as much a concernas pure correlation risk. Correlation estimationsthemselves are of considerable importancebecause of growth in the size of the CDOmarket. It might also be that some activelytrading investors are under-pricing the risk ofmarket liquidity drying up, and are relying onthe assumption that they will be able todynamically hedge their positions in the market.

The policy implication for risk management isthat actively trading banks should stress-testcorrelation estimates (and indeed recovery rateestimates on CDO portfolios) and have in placeboth adequate models to assess and evaluate allmaterial risks related to these instruments andappropriate risk controls.

PRICING AND REGULATORY ARBITRAGESome concerns have been expressed that pricingin the CRT market may be heavily influenced byregulatory arbitrage across financial sectors,32

rather than by information on credit riskexposure. However, the banks surveyed saidthat regulatory arbitrage was not to be over-emphasised. It was not found to be the mainmotivation for using CRT. The main motivationwas to optimise economic capital (i.e. byreducing balance sheet credit exposure), toimprove access to funding and to offer broaderservices to clients. To the extent that theinvolvement of insurance companies hasdeclined, concerns over cross-sectoralregulatory arbitrage have declined as well. Inother words the increased bank-to-bankcharacter of the market has, perhaps, lessenedconcerns over regulatory arbitrage. One shouldnote again that the survey sheds no direct lighton the risks borne by insurance companies andhedge funds, as its focus is on EU banks.

BANKS’ RELIANCE ON RATING AGENCIESThe banks surveyed said that in general they didnot rely primarily on rating agencies’assessments. The degree of reliance seemed tobe inversely related to the size andsophistication of the bank. Irrespective ofwhether or not external ratings are better thaninternal credit risk assessment systems, onepolicy implication is that banks which engage inthe more complicated CRT transactions (such astranched synthetic CDOs) and rely excessivelyon external ratings may warrant special scrutinyby supervisors. This is because reliance solelyon external ratings may be indicative of a banknot having adequate risk management systemsin place. A standardised approach of usingexternal ratings may, of course, be an adequateguide for banks engaged in simplertransactions.

Documents

Credit risk transfer by EU banks: activities, risks and ... · Credit risk transfer by EU banks: activities, risks and risk management May 2004 EXECUTIVE SUMMARY This report, prepared