Trichet calls for more transparency, especially for credit derivatives

Jean-Claude Trichet, governor of the Bank of France, said transparency is essential to prevent a “herd mentality” in the financial market that can create artificial swings in market prices. During a keynote address at the Professional Risk Managers’ International Association 2003 European Summit in Paris this morning, Trichet called for a “strengthening of market transparency” and the disclosure of “complete and reliable information”.

He added that “no satisfying disclosure” yet exists for the credit derivatives marketplace, and that while a January study by the Bank for International Settlements cast “some light” on this market, “these efforts should be pursued by central banks as well as market participants”.

Trichet said the rapid development of the collateralised debt obligation and other credit risk transfer markets in the 1990s has “cast doubt on whether pricing reflects the embedded risks”. He added there was evidence that protection sellers were less capable than banks in managing risk, adding that while such instruments have provided diversification at a micro level, from a macro and global perspective it was something that needed to be reflected upon “very carefully”.

Trichet said transparency is not just an issue for investors and savers but a fundamental tenet underpinning anticyclicality. “If information is not transparent, behaving as a ‘herd’ is a natural reaction,” Trichet said. “If you do not know about company X you use company Y [as a proxy].” He also expressed concern about the similar technologies used by a large number of market participants in estimations. “The underlying mathematical assumptions are the same for all. We know they are market assumptions and the underlying mathematics may be significantly more complex.”

He also endorsed regulatory efforts to address procyclicality concerns, and supported the current proposals by the Basel Committee for the inclusion of capital buffers in Basel II, the new capital Accord due for implementation by late 2006. But he added that mark-to-market accounting could exacerbate procyclicality. There is ongoing debate in Europe over the adoption of International Accounting Standard 39, which closely mirrors the ‘fair value’ approach of the US FAS133 for attributing mark-to market values for derivatives positions. Currently France, Germany and Italy have opposed the full implementation of IAS 39. “It could magnify the risks,” Trichet said. Are we going in the right direction?” he queried.

But Trichet said there had been significant progress made in risk management methods and efficient capital management in the past few years. He said that, on balance, the financial institutions had been “fairly resilient” in the current economic climate. He also praised the use of stress testing: “To complement VAR computations with stress scenarios is something that we value,” Trichet said. “All institutions have their particularities, and stress scenarios add to variety.”