Regulators put credit risk transfer in the spotlight

New Angles


Leading financial services regulators have placed the credit risk transfer market under scrutiny to establish if instruments such as credit derivatives and synthetic collateralised debt obligations (CDOs) pose a threat to financial stability.

The Joint Forum – a body of international regulators covering the banking, securities and insurance industries chaired by Gay Huey-Evans, head of the markets division at the UK’s Financial Services Authority (FSA) – is due to issue a final report investigating credit transfer over 13 jurisdictions in September.

The report, conducted at the request of the Financial Stability Forum – set up by international regulators in 1999 to promote financial stability – will look into a number of issues. These include the risks posed by the burgeoning synthetic CDO market, the suitability and concentration of investors buying such instruments, the impact of rating agencies and their methodologies, the role of substitution rights, the valuation of CDOs and secondary pricing, and the conflicts of interest regarding credit information within large investment banks.

The move will also spearhead a drive by regulators from a number of different jurisdictions to fully understand synthetic CDO structures and the risks surrounding such instruments. It may also facilitate better liaison between regulators related to poor practice in the industry.

Although regulators, including Huey-Evans, do not want to pre-empt the results of the final report, initial findings indicate synthetic credit risk transfer does not pose a significant risk to global financial stability.

Huey-Evans does not believe any surveys to date have proven that any particular sector, including the insurance community, has assumed an unduly burdensome exposure to credit risk. “We haven’t found extensive exposure in the UK insurance industry,” she says. But she stressed that the FSA and other regulators are still conducting thorough surveys of their regulated entities, and are in consultations with unregulated institutions such as hedge funds.

John Carroll, part of the prudential risks and accounting department at the FSA, who sits on a Joint Forum working group co-ordinating the study, says although gross credit risk transfer volumes are quite large, net exposures are relatively small. Fitch Ratings issued a report in September last year identifying $1.7 trillion of protection sold, but insurers were net buyers of $303 billion – 18% of the gross figure. “Insurers are taking on a lot [of credit risk], but they are also shedding a lot,” says Carroll. Even though the net figure is in the hundreds of billions, Carroll believes insurers have typically picked up the higher-rated tranches, with specialist monolines in the US picking up a substantial portion.

The purchasers of credit risk are also viewed as diverse, with participants buying such instruments for a number of reasons, including asset enhancement, yield enhancement and arbitrage purposes. “I think the next bit is how they analyse them [CDOs]... especially the analysis of the correlation against the portfolio itself,” says Huey-Evans.

As a result, the Joint Forum will look into the role of the credit rating agencies, specifically highlighting that ratings are ‘context dependent’. “If it is ‘AAA’ or ‘AA’ [tranche of a synthetic CDO], it doesn’t mean it is a ‘AAA’ or ‘AA’ on just one entity,” she says. “It has a variety of other factors surrounding it. That is something we are trying to raise with institutions to make sure they are aware of it.”

Another area regulators are likely to address is the conflict of interest at large financial institutions that receive credit information from primary market activities and whose trading departments are selling synthetic credit-linked products.

“We feel very strongly that that information should be kept separate,” says Huey-Evans. “Credit information from the institution cannot be passed on for inappropriate purposes to the trading side,” she adds. “That is something we are also going to raise.” At present it is unclear how the issue will be resolved.


Huey-Evans adds that end-users buying credit risk are increasingly sophisticated and know what to demand from major dealers. For example, large asset managers and insurers will demand such services as a condition of purchase to allow them to mark-to-market their positions. But even for smaller institutions that do not need to mark-to-market on a regular basis, the emergence of any accounting irregularities will hurt the market in general, says Huey-Evans, and specifically hurt the dealer involved in the transaction.

She also believes the current practice of allowing market forces to discipline dealers is working relatively well. While she admits that some concerns have emerged in the market, especially related to assessing the riskiness of the optionality inherent in synthetic CDOs, she says the credit derivatives market has grown swiftly without any major hiccups. “Like all new products, maybe they are not explained upfront as well as they should be sometimes,” says Huey-Evans. “But I think people understand there is a duty of care to those who are buying these products,” she adds.

Huey-Evans says dealers must clearly articulate the risks to customers. This includes describing the input values, optionality of the structure, risks inherent when the portfolio is stress-tested and the worst-case scenario the dealer has found. If the buyer is still interested, the dealer has the comfort that the investor understands the risks that have to be managed.

Regulators, such as the FSA, believe the predicted strong future growth in the market means dealers that are less than frank with customers face acute reputational risk issues that could preclude them from making money from synthetic credit transfer in the medium term.

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