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Credit risk will be the major preoccupation on the banking horizon in 2002 Back  
The past year was turbulent and credit risk issues were to the fore for finance professionals. This does not look like changing says Conor Griffin and the rating agencies expect 2002 to be another year of record defaults and mounting problem loans, peaking in the third quarter.
As the oldest and most fundamental of the risks associated with banking and finance, it is no surprise to see credit risk appear on any list of the things that keep people in this industry awake at night. However, 2001 saw credit risk firmly re-establish its position as the number one ‘banana skin’ for financial institutions1.
The main reasons for this are as follows:
• The rise in defaults as a result of the global recession;
• The implications for banks’ credit risk systems as a result of the proposed requirements of Basel II regulatory capital framework;
• The growth in the use of complex credit risk transfer techniques such as credit derivatives and the increasing interlinkages between banking and insurance through financial market innovations.

Defaults on the rise
According to Standard & Poor’s2, 2001 was the worst year on record for corporate defaults. 4.09 per cent of all rated issuers defaulted on E130 billion debt during the year. This exceeds the previous record default ratio of 4.01 per cent recorded during the 1991 recession. Downgrades exceeded upgrades by a ratio of almost 3 to 1, which is also a new record. Spreads on corporate debt were double those typically seen in the late 1990’s.
The primary reason for the deterioration in the credit environment is undoubtedly the widespread recession. All regions of the global economy either fell into recession (e.g. U.S.), remained in recession (e.g. Japan) or experienced a slowdown in growth last year (e.g. Ireland).
This downturn, combined with the huge amount of speculative grade lending and investment in the technology and communications sector in the second half of the 1990’s that preceded it, created the circumstances for a deterioration in the credit quality of lending institutions’ balance sheets. The sovereign default of Argentina combined with such high profile bankruptcies as Enron, Railtrack and numerous telecoms collapses were the notable sectoral events.

Basel faulty?
The Basel Committee on Banking Supervision spent most of 2001 refining and amending the Basel Accord it published at the beginning of that year. The major implication of the Accord is a revision of the regulatory capital treatment of the credit risk banks hold on their balance sheets3.
The Accord allows for banks to use internal models to calculate the amount of capital they hold to support their assets. This could lead to potentially large capital savings for those banks that are able to move to the more advanced calculation approaches. However, in order to be allowed to adopt the advanced approaches, banks must convince their national supervisor that they meet a plethora of operational and reporting requirements. Most financial institutions are engaging in a study to allow them assess where their credit risk systems are in relation to the required benchmark that would permit to use the more advanced approaches.
Regardless of the ambitions of an institution, it should be considering how the Basel Accord will affect its future capital requirements, its relationship with regulators and credit agencies and the general perception of the sophistication of its credit risk management processes in the marketplace. Despite ongoing consultation and delays, the Basel Committee remains committed to a 2005 start date for Basel II.

Banking, insurance and complex credit risk instruments
The most obvious sign of the coming together of the banking and insurance worlds has been through the mergers that have created bancassurance groups. However, another way that these industries are becoming more inter-linked is through risk transfer via the capital markets.
Insurance companies have recently begun offloading property and casualty (P&C) exposures to the capital markets through the catastrophe bond and weather derivatives markets. Insurers have also proved to have an appetite to take on credit risk. Banks keen to transfer credit risks engage in securitisation to repackage and sell this credit risk have found insurance companies to be major investors in asset-backed securities. More recently, banks have been able to trade credit risk by entering credit derivatives such as default swaps and total return swaps. Insurers again have been some of the biggest investors in this market as selling credit protection via credit derivatives represents an unfunded form of investing in credit. Insurers generally enter into such credit transactions with banks by means of a ‘transformer’ vehicle that converts credit derivative trades into insurance contracts. The reason insurers are keen to sell credit protection to banks is that they feel this risk is uncorrelated from the main property and casualty risks on their balance sheets and benefits from this diversification.
With reference to credit risk, the development of new credit transfer products and the appetite of insurers for credit risk has contributed to the deepening liquidity of the credit market. However, questions remain over the insurers understanding of the risks associated with these transfer instruments given their distance from the actual exposures underlying the credit derivatives and securitised tranches. Will the insurers’ appetite for banks’ credit risks remain strong in the coming years if they are burned by the current record levels of credit losses?
The past year has been turbulent and credit risk issues were to the fore for finance professionals. This does not look like changing. The bottom of the global downturn may have been reached, but corporate defaults tend to lag the macroeconomy slightly. The rating agencies expect 2002 to be another year of record defaults and mounting problem loans, peaking in the third quarter. However, we are unlikely to see the same number of investment-grade defaults as witnessed in 2001 and should experience an improvement in credit quality and narrowing of credit spreads as the U.S. and EU economies return to growth. S&P identify the principal risks to improved credit quality this year as being related to renewed war or terrorist attacks, the threat of substantial U.S. dollar depreciation, global deflation and investor nervousness of emerging markets as a result of Argentina’s troubles4.
Regardless of the occurrence or otherwise of these risks, 2002 looks like being another year where credit risk will be the major preoccupation on the banking horizon.

1 Banana Skins 2002 - a CSFI survey of the risks facing banks
2 S&P Ratings Performance 2001
3 The EU directive which will translate the Basel Accord in EU law will apply not only to banks but to all EU credit institutions and investment firms
4 ‘2002: Top Global Credit Market Trends’, S&P, January 2002.

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