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Credit derivatives top the list of ‘Banana Skins’ for 2004 Back  
The development of the credit derivatives market has enabled banks to transfer credit risks to other financial institutions, principally the insurance sector, thus protecting themselves. However, the jury is out on whether credit derivatives can effectively mitigate risk. Conor Griffin reports on the 2003 'Banana Skins Report', which reveals that respondents to the 2003 survey have voted credit derivatives as being their main concern over the coming years.
The 2003 Banana Skins report, published by the Centre for the Study of Financial Innovation (CSFI), summarises responses to a questionnaire about the main concerns for the financial system over the next two to three years. A broad range of bankers, regulators, customers and observers from across the EU and worldwide are represented.

2003 was the first year that complex financial instruments topped the poll. The report cites credit derivatives as being the specific instruments that drove this ranking. At this point in the cycle, it is no surprise to see credit risk, the macro-economy, interest rates and equity markets ranked so highly. The prominent position of international regulation and corporate governance in the top ten is the result of Basel II, EU legislation and particular events in the recent past including the fallout from Enron, WorldCom etc in the form of Sarbanes-Oxley. The report states that this is more of a concern due to bankers’ fears of a climate of ‘regulatory overkill’ rather than a worry of not complying with these regulations.

What has driven credit derivatives to the top of this list? Surely credit derivatives can claim some of the risk management plaudits that have seen the banking sector emerge relatively unscathed from recent shocks. In May, Alan Greenspan said ‘even the largest corporate defaults in history - WorldCom and Enron - and the largest sovereign default in history - Argentina - have not significantly impaired the capital of any major financial intermediary’.

With the exception of Japan, and possibly Germany, the banking sector in many developed countries remains in good health. One reason for this is the impact of the first Basel Accord, increasing the amount of capital that banks are required to hold. Secondly, substantially improved data collection and modeling of credit exposures has led to better management in terms of credit approvals and monitoring, and the anticipation and management of instances of failure.

A third key reason has been the development of the credit derivatives market, enabling the banks to transfer credit risks to other financial institutions, principally the insurance sector. Fitch has estimated that the banking sector has so far transferred nearly $100 billion of credit risk outside the sector. But just how successful is this transfer? Several issues with credit derivatives are discussed below.

Definition of credit events
Currently, the restructuring issue is probably the single biggest obstacle to the development of the market. Issuers frequently restructure their debt for a variety of reasons, not only as a precursor to a more serious event such as bankruptcy, and very often the lenders are given improved terms. There have been several instances (i.e. Conseco and Railtrack) where buyers of protection have been able to use such events to their advantage, by opportunistically exercising their option to the detriment of the sellers.

As a result of such disputes, ISDA has had to continuously revise its documentation reflecting changes in market practice. A new Master Agreement was published in January, and new Definitions in February 2003, addressing the most pressing issues, but there was no agreement over the restructuring debate.

Cross-sector risk transfer
The increasing involvement of insurance sellers, combined with a few highly publicised disputes with the bank buyers, have led some people to debate the effectiveness of this risk transfer. Regulatory concern has also been expressed by the FSA about the ability of insurance companies to manage the credit risk assessment process properly, pointing to inadequate systems and controls, a lack of senior management oversight, increased operational risk and the general lack of transparency in this market.

Adequacy of the current regulatory framework
The credit derivative market did not exist when the 1988 Basic Accord came into force, and national regulators have had to introduce domestic regimes. It is therefore feasible to arbitrage regimes, and locate units in countries that have favourable treatment.

It is also feasible for institutions, especially insurers, to build up significant concentrations of correlated credit risk without any necessity to fully identify the positions to the regulators. Disclosure, or lack of it, is becoming a major issue for both regulators and the industry.

Market stability or instability?
The credit derivative market was developed to enable participants to hedge their credit exposures. But at its heart lies a circular argument that may contain the seeds of its own destruction. Buying protection naturally increases the price of this protection. Participants in other markets, seeing the increase in price, take this as an early warning sign of possible referent difficulties, and mark its bonds and shares down. In turn this prompts other investors to purchase more protection.

For example, the price of protection on Commerzbank suddenly rose by 50p.c. at the beginning of October 2002 and then just as rapidly dropped back a month later, despite no overt change in the bank’s financial condition. The price increase was really a reflection of increased demand, exaggerated by a very thin market, rather than any significant change in the underlying fundamentals.

Documentation and confirmations
Ensuring that the documentation creates a legal framework to meet the objectives of all the parties is, as discussed above, a considerable challenge. Many of the major banks are trying to straight through process their credit derivatives by standardising the documentation. But achieving this is proving difficult, and many contracts are still fine-tuned. As a result, confirmations are complex and need to be carefully checked manually to ensure accurate recording on the system.

Valuation and risk management
Valuation is relatively straightforward if there exists a liquid market in the underlying reference asset. For derivatives written on more obscure entities, it is very difficult to establish a fair market value.
There is a wide range of different pricing models available, but each requires highly skilled personnel to operate as they are normally developed internally, plus a careful specification of input data.

Keeping track of all the transactions and measuring the portfolio values, especially when taking into account the correlations between entities, can be extremely difficult without a very comprehensive system.

Risk management of these transactions can also prove difficult, as the underlying reference assets themselves may be highly illiquid, and therefore delta hedging involves considerable basis risk. The credit risk of the transactions needs to be tracked, and integrated with the credit exposures arising from the more traditional business lines.

Operational risk is significantly increased by the complexity of these products, and the need to track the reference entity and reference asset carefully. Many banks are using IT systems that were not specifically designed to manage credit derivatives, or even spreadsheets, which means that there is a considerable potential for risk.

The credit derivative market is rapidly growing both geographically and in depth. Currently it is the larger institutions that are operating in this market. However, smaller institutions, who often have very little opportunity to diversify their risks naturally, could be major beneficiaries.

In the long-term, an important question is how much credit risk is going to be reallocated around the banking sector, and how much will be transferred to non-banks? Currently the latter is increasing rapidly, but if deficiencies in risk management, controls and documentation continue, this may be a short-term phenomenon. If the insurance sector continues to take on credit risk, and there is a sudden downturn in the economy, it is likely that they would look to the banks for liquid funds. Will the transfer of credit risk eventually complete a full circle?

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