FSA chairman voices CDO concerns

The Financial Services Authority (FSA), the UK's principal regulator, is concerned that the rapid growth of credit risk transfers between banks and insurers/ reinsurers could affect financial stability.

Speaking at the annual Association of Insurance and Risk Managers lecture in London, FSA chairman Howard Davies highlighted collateralised debt obligations (CDOs) and synthetic CDOs – structured products that use credit derivatives to transfer credit risk – as being of particular concern.

“One investment banker recently described synthetic CDOs to me as ‘the most toxic element of the financial markets today’,” said Davies. “This is why we and the Bank of England have been looking hard at these risk transfers, and importantly at the motivations for them,” he added.

Davies said insurance companies – which often invest in the senior tranche of a CDO – may not be pricing risk appropriately, “perhaps because they lack the sophisticated technology to price them that investment banks possess".