Cross-sector risk transfer regulations should be reviewed, say FSA respondents

The UK's Financial Services Authority (FSA) recently released feedback on responses to Discussion Paper 11, which focused on the effects of risk transfer between the banking industry and the insurance industry via credit derivatives and related products, and how this area should be regulated in the future.

As credit defaults escalated in 2002, regulatory authorities in Europe and the US grew concerned that banks were transferring the less attractive portions of the credit risk in their loan portfolios to the insurance sector via collateralised debt obligations (CDOs). The FSA issued is Discussion Paper 11 in May 2002, and asked for comments from the market.

In the response paper, published in December, respondents suggested five key issues should be addressed more specifically in the review of the proposed revisions to the Basel Accord, including: disproportionately high capital deductions on retained risks; the need for tail risk to be transferred; the lack of appropriate treatment of unexpected losses; the lack of recognition of double default risk; and the absence of even a partial benefit where risk-sharing occurs.

Respondents also noted that regulators should look at the capital differential between banks and insurers, as well as the capital reduction that can be achieved through a swap transaction that cannot be achieved through a nearly identical insurance solution.

While the FSA’s reactions to these responses were somewhat general, the regulatory body did say it would seek to monitor the credit risk transfer markets “through our firm-specific supervision and further occasional thematic initiatives”. The FSA also said it does not “propose at present to issue guidance on the boundary between credit derivatives and insurance”.

Said the FSA: “We continue to keep credit risk transfers on our risk radar as part of our oversight of market developments and of our firm-specific supervision. Where these activities are significant, we take them into account in our risk assessment and risk mitigation programme for individual firms.”BaselAlert.com