Overview of the Credit Risk Transfer Market

Memories of the bankruptcies of Enron, WorldCom and United Airlines have already faded. The banking world weathered these potentially disrupting bankruptcies thanks to the key role of credit risk transfer. Credit risk, a risk that the borrower may fail to meet his contractual obligation, has a strong impact on a bank’s profitability, regulatory capital adequacy and solvency. Banks face a variety of risks such as credit, market, interest rate, liquidity and operational risks. However, financing of assets being the core activity, a bank is predominantly exposed to credit risks and managing credit risk becomes critical for a bank.

Drivers of Credit Risk Transfer

Traditionally, banks have been originating and holding credit exposures and associated risks until maturity. To control credit risks, borrower investigations and thorough credit appraisals were used during the origination stage. Such a passive ‘originate and hold’ approach was insufficient to contain credit risks that could arise during the tenure of credit exposure due to adverse changes in economic, business and financial environments or due to inaccurate estimation of credit risks.

Participants in the credit markets have different and changing risk profiles, appetites and outlooks. With growing business complexity, banks need to have sophisticated ways of risk management. Some market participants who can’t take direct credit exposures want to participate indirectly for yield improvements and portfolio diversification. The need for active management of acceptable risks, mitigation, offloading and distribution of undesired risks, yield improvement and portfolio diversification led to the development of a CRT market. CRT facilitates reallocation and dispersion of credit risk across financial and non-financial sectors of the economy. The main participants in the CRT market are:

• Risk originators, such as banks, financial institutions and investment banks that seek protection against credit risk, i.e. protection buyers.
• Intermediaries, like banks and investment banks, who structure or arrange CRT deals or act as market makers and sometimes warehouse CRT transactions.
• Protection sellers, i.e. risk takers. These include banks, insurance companies (including monoline financial guarantors) and hedge funds.

Instruments and Markets

Active risk management can be done via risk shedding or hedging. Risk shedding is undertaken when a bank wants to remove the credit risk and the underlying asset from its balance sheet as in the case of loan trading and traditional securitisation. Risk hedging is undertaken when a bank wants to retain an asset on its balance sheet, but wants to transfer the credit risk completely or partially. Hedging instruments include insurance products, credit derivatives and securitization.

CRT instruments can be broadly classified as insurance products or capital market products depending on which sector provides credit protection. These boundaries have now blurred with insurance sector participating in capital markets through credit derivatives and securitization.

Insurance Products

Insurance companies provide credit protection through instruments such as a surety bond, financial guarantee, letter of credit and credit insurance. Here, the asset under protection remains on the balance sheet of the protection buyer and credit risk to the extent of coverage is transferred to the protection seller. Insurance products do not allow separation of credit risk from the underlying asset, thus credit risk cannot be traded and protection needs to be held till maturity. These products are not popular as settlement can be tedious and time consuming in case of default.

Capital Market Products

This category includes CRT products such as loan sale, securitisation, and credit derivatives. In a loan sale, the asset and its credit risk are transferred completely from a seller to a buyer through outright sale. There is no dissociation of credit risk from the asset. Loan sale frees up associated regulatory risk capital but affects client relationships. Though not popular, this segment has grown steadily over the years. According to Loan Pricing Corporation, the secondary loan market in the US¹ has increased from US$102bn in 2000 to US$176bn in 2005.

Securitization involves pooling and repackaging exposures into multiple tranches, each tranche with a distinct credit risk. It allows the credit risk to be dissociated from the underlying asset and to be traded independently from the asset. In traditional securitisation, investors take over credit risks from originators. In synthetic securitisation, assets remain on balance sheet of an originator and credit risks are transferred to a third party using credit default swaps. Securitisation of commercial credit exposures is a relatively new and developing market. According to Lehman Brothers, the global collateralised debt obligation (CDO) market increased from US$90bn in 2000 to US$270bn in 2005.

Credit derivatives² are the most popular instruments of CRT. A protection buyer pays a premium to a protection seller who is liable to pay protection buyer in case of credit event such as default, rating degradation or restructuring. Credit derivatives are used for partial or full hedging of credit risks of either a single exposure or portfolio of exposures. As credit derivatives facilitate the transfer of credit risk while retaining assets on the balance sheet, a bank can maintain important client relations. The credit derivatives market has grown exponentially from US$893bn in 2000 to US$20 trillion in 2006³ and is expected to be at US$33 trillion by 2008, according to a report from the British Bankers’ Association (BBA). Though investment grades and corporate assets are common as reference entities, participants are taking efforts to develop the market in sovereign, high yield, lower rated and unrated sectors and in different maturities.

Factors Affecting CRT Instrument Choice

Choice of CRT instrument depends on various factors, such as the objectives behind CRT, credit quality (asset health), liquidity, depth and breadth of financial markets, cost of CRT (insurance can be costlier than loan sale), extent of coverage available (types of credit events), existing regulatory capital levels (loan sale frees up regulatory capital whereas insurance does not offer such a benefit) and heterogeneity of balance sheet assets.

Concerns Facing the CRT Market

A BIS Joint Forum report on CRT identifies the following three important regulatory concerns from a financial stability perspective:⁴

• Whether CRT transactions accomplish a clean transfer of risk.
• The degree to which CRT market participants understand the risks involved in CRT.
• Whether CRT activities are leading to undue concentrations of credit risk inside or outside the regulated financial sector.

Using credit derivatives does not achieve a clean transfer of credit risk, as the CRT process leads to other forms of risk that may make the transaction less effective. Protection sellers and intermediaries face credit risk acquired from protection buyers, model and pricing risk and liquidity risk. At the same time, protection buyers face counterparty risk that can be mitigated by netting and high collateral backing and legal risk, i.e. the contract may not be enforceable. Other risks in CRT include correlation risks between reference entities, counterparties and collateral; basis risk due to hedging imperfections in the underlying and reference asset; and operational risks. Due to these risks in CRT, it is difficult to estimate effectiveness of CRT transactions.

There is a regulatory concern that protection buyers and protection sellers are not equal in terms of borrower information, risk assessment capabilities, financial sophistication in pricing and valuation of complex CRT instruments. Though there have been instances of misjudging and mispricing of risks resulting in losses for some participants, most players are capable and sophisticated enough to deal in the CRT market.

The credit derivatives market is concentrated among the top 10 counterparties that together hold 70% of the market share. There is a real concern that market-making activity by limited participants may create a false sense of liquidity and a default or exit by a single participant could have a significant impact on the credibility and future growth of the CRT market.

Conclusion

Participants in the market, as well as regulators, have recognized the benefits of CRT as it has proved its effectiveness in softening the impact of credit downgrades, bankruptcies and recession. However, with convergence of financial and non-financial sectors in the CRT market, regulators are duly concerned about implications of CRT for the stability of global financial markets.

Though growing rapidly, the CRT market is small and narrow compared to bank outstandings and also compared to other derivatives market, indicating its good growth potential. It will continue to grow wider and deeper with external and internal emphasis on risk management, new product innovations and improved sophistication of participants in handling complexities of CRT transactions. Though the CRT market has rapidly and healthily grown into a trillion dollar market, it may face some hurdles in future, particularly during credit downturn and adverse systematic events. Here CRT may get down temporarily, but it will surely not be out. The CRT market is set to become bigger, better and more interesting in the future.

References

• IMF Global Financial Stability report, April 2006.
• Report on Credit Risk Transfer by the Joint Forum of BIS, March 2005.
• BBA Credit Derivatives report, 2006.
• European Central Bank report titled ‘Credit Risk Transfer by EU banks: Activities, Risks and Risk Management’, May 2004.
• Committee on Global Financial Systems report on ‘Credit Risk Transfer’, January 2003.
• Risk transfer between banks, insurance companies and capital markets: an overview – Financial Stability Review: Article by David Rule, Financial Surveillance Division, Bank of England – December 2001.
• Loan Pricing Corporation website for data on US Secondary loan.