The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions

Contributor Notes

Author(s) E-Mail Address: jchanlau@imf.org and long@imf.org

The increasing ability to trade credit risk in financial markets has facilitated its dispersion across the financial and other sectors. However, specific risks attached to credit risk transfer (CRT) instruments in a market with still-limited liquidity means that its rapid expansion may actually pose problems for financial sector stability in the event of a major negative shock to credit markets. This paper attempts to quantify the exposure of major U.K. financial groups to credit derivatives, by applying a vector autoregression (VAR) model to publicly available market prices. Our results indicate that use of credit derivatives does not pose a substantial threat to financial sector stability in the United Kingdom. Exposures across major financial institutions appear sufficiently diversified to limit the impact of any shock to the market, while major insurance companies are largely exposed to the "safer" senior tranches.

Abstract

The increasing ability to trade credit risk in financial markets has facilitated its dispersion across the financial and other sectors. However, specific risks attached to credit risk transfer (CRT) instruments in a market with still-limited liquidity means that its rapid expansion may actually pose problems for financial sector stability in the event of a major negative shock to credit markets. This paper attempts to quantify the exposure of major U.K. financial groups to credit derivatives, by applying a vector autoregression (VAR) model to publicly available market prices. Our results indicate that use of credit derivatives does not pose a substantial threat to financial sector stability in the United Kingdom. Exposures across major financial institutions appear sufficiently diversified to limit the impact of any shock to the market, while major insurance companies are largely exposed to the "safer" senior tranches.

I. Introduction

The increasing ability to trade credit risk in financial markets has facilitated the dispersion of risk across the financial and other sectors. Credit risk transfer (CRT) instruments—such as credit derivatives and structured credit products—enable institutions to reduce their concentration of risks by passing on the “unwanted” risks. In other words, they provide a stabilization mechanism similar to that of reinsurance for the insurance sector (IAIS, 2003). Banks, in particular, can diversify their credit risk exposure by transferring it to other banks, or more importantly, can achieve much larger diversification gains by shifting the risk outside the banking sector itself.3 Theoretically, the net outcome of CRTs should be one of benefit, with a positive impact for overall financial stability and efficiency.4

However, there are specific risks attached to CRT instruments which could be heightened, in a relatively “new” market, by the still-limited liquidity and lack of transparency in some segments. Notably, the complexity of quantitative techniques required to value and hedge these instruments is not yet completely understood, exposing market participants to potentially large losses. The situation is compounded by problems associated with, among other things, the creditworthiness of transaction counterparties, and the adequacy of existing market and legal infrastructure. Increasing interlinkages between financial institutions raise the question of whether institutions fully understand their risk exposures. For instance, while banks are shedding credit risk to insurance companies, life insurers are using capital markets and banks to hedge some of their portfolio risks (Rule, 2001). Substantial losses in credit markets experienced by German Landesbanks in 2002–03 suggest that some active participants in the market might not have the capacity to adequately manage the risks associated with CRT instruments.5

Thus, a key concern among regulators is that the rapid expansion of CRT markets may actually pose problems for financial sector stability, if a significant market event were to occur. In their increasing search for yield in recent years, a wide variety of investors—some with little experience managing credit risk—have become active sellers of protection. Justifiably, regulators worry whether a major shock in credit markets could cause substantial and widespread losses among these investors, forcing a disorderly unwinding of credit risk positions. The general lack of accurate data on open positions in credit derivatives and structured credit instruments further increases the risks for financial stability by masking the extent of institutions’ involvement with these products. Such risks arise from the ability of investors to leverage their positions substantially compared to similar positions in cash instruments such as loans or bonds.

This paper examines the financial stability issues related to CRT markets, focusing in particular on the use of credit derivatives in the banking and insurance sectors in the United Kingdom.6 Within the financial sector in the United Kingdom, globally active banks such as Barclays, Hongkong and Shanghai Banking Corporation, and Royal Bank of Scotland are believed to be more exposed to CRT instruments than insurers. That said, other financial institutions have also become increasingly more active in the CRT market. Our findings suggest that diverse holdings across major financial institutions potentially active in the credit derivatives market may limit the extent of any impact from a negative shock to the market, and that insurance companies, at least the major publicly listed ones, appear to be more exposed to “safer” senior tranches.

The paper is structured as follows. Section II examines the growth of credit derivatives instruments and the proliferation of structured credit products in the global market. Section III considers the risks inherent in the CRT market, and the increasing interlinkages among financial institutions. Section IV presents the empirical evidence on the exposure of financial institutions in the United Kingdom to credit derivatives products. Issues of market regulation and supervision are covered in Section V. Section VII concludes.

II. Credit Risk Transfer Instruments: Structured Credit Products and Credit Derivatives

The exponential growth of the global credit derivatives market since the instrument was first traded in 1996 has played a key role in the development of the CRT market. A credit derivative is a contract (derivative security) that is used to transfer to another party the risk that the total return on a credit asset would fall below an agreed level. This is usually achieved by transferring the risk on a credit reference asset. It does not require the transfer of the underlying asset, although the cash flow of the credit derivative instrument is determined by the credit quality of the underlying asset.7 According to the British Bankers’ Association (BBA), the value of credit derivatives products, which exceeded even the total volume of outstanding U.S. Treasury bonds at the end of 2004, is projected to surpass $8 trillion by 2006 (Figure 1).

Figure 1.
Figure 1.

Growth of the Global Credit Derivatives Market

(In billions of U.S. dollars)

Citation: IMF Working Papers 2006, 139; 10.5089/9781451863994.001.A001

Source: British Bankers’ Association.

Among the most popular structured credit products are collateralized debt obligations (CDOs).8 CDOs are constructed by “pooling” the credit risk of different financial instruments and dividing the pooled credit risk into tranches with different risk and return characteristics (Appendix I).9 CDOs generally combine three mechanisms common to all securitization structures (Cousseran and Rahmouni, 2005):

  • the construction of a reference portfolio comprising a pool of bank loans and/or negotiable financial instruments and/or credit derivatives;

  • the de-linking of the credit risk of the portfolio from that of the originator of the portfolio via the use of a Special Purpose Vehicle (SPV) that issues the CDO and holds the underlying assets; and

  • the tranching of CDOs backed by this portfolio, with specific seniority rank in terms of rights to cash flows generated by the underlying assets.

Motivations to issue CDOs are varied. They include arbitrage opportunities (from attractive excess spreads coupled with low default rates); balance sheet management (reduced cost of funding and meeting regulatory capital requirements); providing fund managers with the opportunity to earn a stable fee income and to increase their assets under management; providing investment banks the opportunity to earn underwriting fees and cross-sell collateral into CDOs (Memani, 2005). In other words, legal, regulatory, and economic incentives have typically been the key drivers of growth in the CDO market. In addition, the underlying bond and loan secondary markets are relatively illiquid. Thus, CDOs help to improve liquidity, raising the total valuation to the issuer of the CDO structure (Duffie and Garleanu, 2001).

Participants in the CRT market have also become increasingly diverse. According to Fitch Ratings (2005), the main participants in the CDO market are lending institutions, which are usually net buyers of protection or net sellers of CDOs, and insurance companies, which are net sellers of protection and net buyers of CDOs. The most recent credit derivatives survey by the BBA suggests that while banks, securities houses, and insurance companies still constitute the majority of market participants, hedge funds have emerged as key players, both as protection buyers and sellers (Figure 2).10 According to data from Credit Suisse First Boston (CSFB), the investor base (sellers of protection) has broadened more recently to include hedge funds, proprietary traders, and the more traditional asset management industry, who participate in both the protection buyers’ and sellers’ markets (Figure 3). Even some pension funds, which have generally followed conservative investment strategies, are said to have started taking on the role of protection sellers.

Figure 2.
Figure 2.

CDOs: Protection Buyers and Sellers

Citation: IMF Working Papers 2006, 139; 10.5089/9781451863994.001.A001

Source: British Bankers’ Association.
Figure 3.
Figure 3.

Composition of Protection Sellers (Buyers of CDOs)

Citation: IMF Working Papers 2006, 139; 10.5089/9781451863994.001.A001

Source: Credit Suisse.

The growth of credit derivatives has provided the impetus for the sharp growth in synthetic CDOs since the latter are easier to assemble and disperse than their cash counterparts (Figure 4).11 According to BBA (2004), synthetic CDOs make up about 16 percent of the credit derivatives market, behind CDSs, which have a 51 percent market share. Indeed, synthetic CDOs, which insured less than $400 billion of the face amount of U.S. corporate bonds in 2001, are estimated to have covered some $2 trillion by the end of 2005, according to JPMorgan. As a benchmark comparison, this would represent about 40 percent of the entire U.S. corporate bond market of almost $5 trillion.12 The demand for these instruments has been particularly strong in Europe, driven by the existing legal and taxation barriers to securitization transactions involving the true sale of underlying assets and the limited interest in these transactions for refinancing purposes (Cousseran and Rahmouni, 2005). Further, the outstanding volume of corporate bonds in Europe is much smaller than in the United States, making it more difficult to source assets for cash CDOs.

Figure 4.
Figure 4.

Growth of the Global Synthetic CDOs Market

(In billions of U.S. dollars)

Citation: IMF Working Papers 2006, 139; 10.5089/9781451863994.001.A001

Source: JPMorgan.

III. Interlinkages across Financial Institutions

Within the financial system, there are increasing linkages across different financial sectors, especially among banks and insurers.13 Insurance companies are major investors in banks’ equity and debt instruments, which exposes them to risks taken by banks. Insurers also cover banks and their customers for the usual insurable risks; they provide companies with trade credit insurance, while banks often finance these “receivables,” supported by insurance. Meanwhile, banks provide insurers with liquidity facilities to enable them to pay current claims and with letters of credit as evidence of their ability to pay future claims.

The formation of bancassurance groups through the merger of banks with insurers represents another example of cross-sector linkages. In the United Kingdom, for example, ownership interests of U.K. banks in insurance companies have been significant, with 6 of the 10 largest U.K.-owned banks having equity shares in life insurance subsidiaries at end-2003. This is in contrast to the direct credit exposure of U.K. banks to the life insurance sector, with loans to insurers and pension funds amounting to just over 6 percent of the major banks’ Tier 1 capital. Existing empirical evidence shows that the equity prices of individual bancassurers in the United Kingdom were adversely affected by disruptions in the U.K. life insurance sector over the 2001–03 period, suggesting a spillover effect though ownership links (Monks and Stringa, 2005).

Meanwhile, the development of techniques to repackage credit risk into “slices” has facilitated the increasing shift of credit risk away from the banking sector.14 Credit risk has been transferred to insurance companies and to other capital market participants such as hedge funds, mutual funds, and pension funds.15 Banks account for the major share of CRT market activity—they use CRT instruments for diversifying or hedging risks in their banking books (portfolio management). Banks also provide investor services by devising and intermediating CRT products and make markets for credit derivatives (ECB, 2004). Individual banks could be involved in both portfolio management and intermediation activities. In the United Kingdom, the larger banks (by assets) participate in the CRT market.

Within the European Union, insurance companies are the largest buyers of credit risk outside the banking system (ECB, 2004). Different types of insurers have been using CDOs and CDSs to take on credit risk at varying levels of seniority and forms, commensurate with their balance sheet needs and regulatory restrictions (see Rule, 2001). In countries such as Denmark, German, Japan, the Netherlands, and the United Kingdom, life insurers are reportedly seeking more credit risk in order to increase the yield on their assets. Ironically, these investors may then have to seek recourse from their respective banks by drawing on their credit lines if losses crystallize during a credit event, in order to meet their obligations under these CRT instruments.

The transfer of credit risk between institutions also gives rise to several other risk factors.16 Market risk is associated with changes in the credit spreads of names in the underlying portfolio of a CDO tranche. The seller is often exposed to liquidity risk as well, as it may be difficult to sell an asset quickly in an insufficiently liquid secondary market. That said, investors with less liquid liabilities than banks such as life insurers and hedge funds may benefit from the liquidity premium. The use of standardized tranches on credit derivatives indices to hedge exposures to single tranches gives rise to basis risk, since the instruments are not perfectly matched. Counterparty risk arises from the possibility that the risk buyer may default in settling a claim, while legal risk refers to the lack of complete and timely documentation, in the event of a dispute over a particular transaction. Ratings risk arises from the fact that ratings tend to reflect the average risk of a security, without factoring in the dispersion of risk around its mean (Cousseran and Rahmouni, 2005). This may limit the usefulness of ratings given the structured nature CDOs.17 There is also the possibility of “ratings arbitrage,” wherein CDO issuers may be tempted to choose rating agencies based on the best rating that is assigned to their particular issue or tranche, to minimize funding costs. Model risk arises in the valuation of CDOs using a myriad of complex models that continue to evolve.

IV. Exposure of U.K. Financial Institutions to Credit Derivatives

A direct assessment of the exposures of financial institutions in the United Kingdom to credit derivatives—and their implications for financial stability—is not possible, given the lack of available information in this area. To overcome this limitation, we estimate the exposure of a firm to the credit derivatives market by examining the extent to which developments in the credit derivatives market explain the variability of the firm’s equity returns in the longer run. The assumption that such a relationship exists is reasonable, given that gains/losses on holdings of CRT instruments are quickly manifest in a company’s financial data in an efficient market.18 We assess this exposure indirectly by using the vector autoregression (VAR) approach first suggested by Hasbrouck (1991a, 1991b). In this case, we estimate the model using daily data for the period August 28, 2003–September 15, 2005.

The choice of factors in our model is guided by the requirement that the econometric model captures both systemic risk in the financial system and the specific risk associated with credit derivatives products. The major financial services groups analyzed here represent either the largest life insurers or major banking groups, which list their shares locally in the United Kingdom: Aviva, Barclays, Halifax Bank of Scotland (HBOS), Hongkong and Shanghai Banking Corporation (HSBC), Lloyds, Legal and General, Royal and Sun Alliance, and Royal Bank of Scotland (RBS).

Market prices are used in our analysis, because they are readily available on a daily basis (as opposed to accounting data), and quickly transmit financial information about individual companies.19 Equity prices for the major financial groups are obtained from Bloomberg L.L.P. The slope of the yield curve, measured as the difference between the yields on the 10-year and 2-year U.K. government bonds, is included as a measure of contemporaneous economic conditions that would lead to simultaneous movements in equity returns and structured credit product prices. The yield data are obtained from the generic 2-year and 10-year yield series constructed by Bloomberg L.L.P.

While there has been a rapid proliferation of CRT products, credit derivatives are among the most widely used products. Consequently, the introduction and rapid acceptance of benchmark credit derivatives indices, specifically iTRAXX in Europe, has helped develop a two-way market for standardized CDOs. Given that the tranche seniority of a CDO affects its riskiness, we include as factors the prices of the equity tranche and a number of mezzanine tranches with varying degrees of seniority.20 The super-senior tranche is not included in the analysis since its time series just started in mid-2004. Price data for the different tranches are obtained from JPMorgan.

Given the vector of n endogenous variables, Yt=(y1t, y2t,…, ynt)′, the corresponding unrestricted VAR system of order p is given by:

Yt=c+Φ1Yt1++ΦpYtp+εt,(1)

where c is an n-vector of constant terms, Φi (i=1,…, p) are n-by-n coefficient matrices, and εt is a vector of uncorrelated, independent, and identically distributed error terms. The error terms are also serially uncorrelated. Under certain technical conditions, described in detail in econometrics texts like Hamilton (1994), the vector autoregression system in equation (1) admits the following vector moving average representation (VMA):

[y1tyitynt]=[ψ11(L)ψ1i(L)ψ1n(L)ψi1(L)ψii(L)ψin(L)ψn1(L)ψni(L)ψnn(L)] [ε1tεitεnt],(2)

where ψij=k=1ψijkLk ,i,j=1,,n are lag operators.

The coefficient ψijk measures the effect k periods ahead of a unit shock or innovation to variable yj on variable yi. Therefore, the long-term cumulative impact of variable yi on variables can be measured by adding up the coefficients associated with the lag operator ψij(L):

k=0ψijk=information content ofyj on yi.(3)

Equation (3) suggests that variance decomposition can be used to quantify the overall importance of innovations to variable yi for explaining subsequent realizations of variable yi vis-à-vis the other endogenous variables. Specifically, the overall importance of variable yj is captured by the relative share of the variance of variable yi that it explains:

(k=0ψijk)2σεj2m=1n(k=0ψimk)2σεm2,(4)

where σεj2 is the variance of the innovation to variable yj. Note that our VAR framework does not choose a particular ordering of the variables entering equation (1), and hence it is a statistical description of the dynamic interrelations among the variables analyzed. While a structural VAR may offer some advantages for interpreting the data, it requires specifying a priori a causal ordering of the variables, which we do not deem appropriate for this study.

In interpreting the results, we do not make any assumption as to whether a particular institution is long or short the credit exposure. We assume that, in case of defaults, losses fall within the attachment and detachments points of the benchmark iTRAXX. Therefore, the higher the fraction of equity return volatility explained by a senior tranche, the lower both the credit exposure of the firm and the potential impact on financial stability.

Our empirical results suggest that U.K. insurance companies tend to have more conservative exposures to the CRT market. Table 1 shows the longer-term impact of volatility in the credit derivatives market on the stock price returns of our sample companies.21 The major insurance companies tend to be more exposed to volatility in the more senior mezzanine tranches, with attachment points of 9–12 percent and 12–22 percent.

Table 1.

Impact of Volatility in the CRT Market on Major U.K. Financial Groups, August 2003–September 2005

(In percent)

article image
Sources: Bloomberg L.L.P. and IMF staff calculations.Note: Shaded numbers represent individual institutions’ biggest exposure to the corresponding credit derivatives tranche.

In contrast, the bancassurance businesses tend to be more exposed to riskier CRT products. They appear to have greater exposure to the junior mezzanine tranches (with attachment points of 3–6 percent and 6–9 percent), with the exception of HBOS. The apparent conservatism of HBOS, which is substantially exposed to the senior mezzanine tranche (with attachment points 12–22 percent), could possibly be explained by the fact that it is also the biggest life insurer in the United Kingdom, in addition to being one of the five biggest banks in the country. Barclays also appears to be most exposed to the senior mezzanine tranche.

The empirical evidence suggests that the CRT market does not pose a substantial threat to financial sector stability in the United Kingdom, at this point. While our sample of financial institutions is admittedly rather small, thus making it difficult to generalize this finding, the results suggest that: (i) there are sufficiently diverse holdings across major institutions in the U.K. market, which are potentially active in the CRT market, to limit the extent of any impact if markets were to experience a negative shock; and (ii) insurance companies—at least the major ones—which are risk buyers, appear to prefer the tranches that better insulate them from first losses.22

In our view, an important threat posed by a credit event in the credit derivatives market is that of reputation risk, which could result in contagion. In other words, the failure of one financial institution could have the knock-on effect of denting public confidence in the financial sector in general, especially given the increasing interlinkages among different segments of the financial sector. In the United Kingdom, inter-relationships between the banking and insurance sectors are especially significant, as discussed earlier. In the current environment, where the market is rapidly evolving and credit yields remain relatively low, institutional investors may be tempted to take riskier bets and move down the credit spectrum to increase the returns on their investments. It is thus important for authorities to continue monitoring developments in these markets and to obtain more detailed information on the exposure of institutions—identified by supervisors as being potentially systemic—to CRT products.

V. Regulatory and Supervisory Initiatives

Credit derivatives markets allow for a better distribution of risks across different segments of the financial sector. As such, the development of the credit derivatives market should be encouraged. The challenge for regulators is to implement regulatory measures and provide adequate supervision and surveillance to prevent the misuse of these instruments, while providing an environment that encourages further development of this market. This section briefly discusses key initiatives taken by the financial authorities in the world’s two biggest CRT markets, namely, the United Kingdom and the United States.

In the United States, the advent of securitization exposed major deficiencies in regulatory and supervisory practices.23 The U.S. authorities realized that while regulatory and accounting reforms were important, proper supervision of the market would require adequate resources and relevant experience on the part of supervisors.24 As a result, the Office of the Comptroller of Currency (OCC) implemented supervisory reforms related to securitization exercises by banks. These include:

  • developing a cadre of specialized experts to examine securitization programs;

  • recognizing that these examinations require extraordinarily high person-hour expenditure;

  • developing independent valuation capabilities for the residual risk component;25 and

  • obtaining information on every securitization vehicle for every bank.

In terms of banking practice, the OCC has recommended that banks should:

  • encourage an independent legal and accounting review of every vehicle;

  • perform “stress to breakage” risk analysis to complement their residual risk valuation; and

  • put in place contingency liquidity and reserve planning.

In the United Kingdom, the Financial Services Authority (FSA) posits that understanding the extent to which real risk is transferred is key when monitoring the CRT market.26 To this end, the FSA has engaged in surveys—in particular, through the Joint Forum—to understand who the end investors are and how well the risks are managed.27 The FSA maintains a conservative approach with respect to data collection on a regular basis given its view that such exercises incur high costs and provide limited benefits, under its existing cost-benefit framework for regulation. The supervisor is also prioritizing the issue of model risk by initiating the hypothetical portfolio exercise to better understand how firms are modeling CRT instruments and to discover the challenges across firms. In the meantime, the FSA and the New York Federal Reserve are currently working with major participants in the CRT market to resolve the issue of backlogs in trade confirmations and assignments.

Meanwhile, the strengthening of reporting standards will likely improve disclosure in the financial sector. Notably, the promulgation of International Financial Reporting Standards (IFRS) points to the likelihood of more accurate valuations of structured credit and credit derivatives instruments in the financial statements.28 International Accounting Standard (IAS) 39, which is still undergoing revisions, introduces the use of fair value accounting for financial assets and liabilities of listed companies. Essentially, credit derivatives held in the trading book of a bank would have to be recorded at fair value under this standard. Within the banking book, the purpose of the instrument is key to determining its valuation in the financial statements. Credit derivatives used to hedge underlying transactions in the banking book would have to be recorded at fair value, while the same instruments may be recorded at cost if the objective is to hold them to maturity.29

There are several areas where improvements in supervision and surveillance could be effected in markets where CRT instruments are becoming more important. Specifically, the authorities should: (i) ensure that supervisory staff are always up to date with the latest techniques and tools; (ii) ensure that all paperwork relating to CRT transactions are timely and kept up to date; (iii) ensure that risk management systems are adequate to cope with stresses in the credit derivatives market and encourage continued improvements in credit risk management; (iv) require financial institutions to regularly stress test their open positions in CRT instruments, notably in structured credit exposures; (v) encourage market participants to consider richer and more consistent risk measurement techniques, in addition to formal ratings of CRT instruments; and (vi) consider the need for greater disclosure by financial institutions of their holdings in CRT instruments.

VI. Conclusion

The increasing ability to trade credit risk in financial markets has facilitated the dispersion of risk across the financial and other sectors. Theoretically, the net outcome of CRTs should have a positive impact on overall financial stability and efficiency. However, there are specific risks—such as modeling risk, legal risk, and counterparty risk, among others—attached to CRT instruments which could be heightened by the still-limited liquidity in the market. Thus, a key concern is that the rapid expansion of CRT markets may actually pose problems for financial sector stability in the event of a major negative shock in credit markets.

This paper focuses on the use of structured credit products in the banking and insurance sectors and its implications for financial sector stability in the United Kingdom. Given the lack of publicly available information on the exposures of financial institutions to CRT instruments, an indirect method using VAR is applied instead, to readily available financial market data. We do not make any assumption as to whether a particular institution is long or short the credit exposure; rather, we merely assume that losses fall within the attachment and detachment points of the standardized credit derivatives benchmark, in case of defaults.

Our empirical results indicate that the structured credit market may not pose a substantial threat to financial sector stability in the United Kingdom at this point. U.K. insurance companies tend to be more conservative in taking on CRT exposures, preferring the “safer” senior tranches, while their bancassurance counterparts tend to be more exposed to the junior mezzanine tranches. The apparent diverse holdings across these major financial institutions, which are potentially active in the structured credit market, may limit the impact of any significant negative shock to the market.

In this relatively “new” market, the challenge for regulators is to ensure adequate regulation, supervision, and surveillance, while encouraging the development of this market. Financial authorities in key CRT markets have taken important regulatory and supervisory initiatives to mitigate the risks posed by the rapid growth and evolution of this market and are continuing to enhance their supervision and surveillance techniques.

The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions
Author: Ms. Li L Ong and Mr. Jorge A Chan-Lau