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On Credit Risk Transfer Instruments and Central Banks

Keynote Speech given by Kazuo Ueda, Member of the Policy Board, at the ISDA 18th Annual General Meeting in Tokyo, on April 10, 2003.

April 18, 2003
Bank of Japan



It is a great honour for me to address this audience. It is also a timely opportunity for me for the following reason. I had already decided a few weeks ago to talk about credit risk transfer instruments. Then, just the day before yesterday, the Bank of Japan's Policy Board decided at the Monetary Policy Meeting to examine the possible purchase of asset-backed securities. Before I explain the background for the decision, however, let me review the development and function of credit risk transfer instruments.

I. Development of Credit Risk Transfer Instruments

The growth of the credit risk transfer market is increasingly attracting the attention of the central banking community, as illustrated by the Bank of Japan's decision. Credit risk transfer instruments, in themselves, are nothing new. It is said the oldest financial guarantee contract dates back to 670 BC, and such guarantees have been a part of financial business worldwide. However, the need for risk diversification coupled with IT innovation is adding to the growth momentum.

As you well know, since the 1990s we have seen a proliferation of new types of credit risk transfer instruments. Annual arrangements in the syndicated loan market in the US exceed 1 trillion dollars and are growing in the Japanese market as well. In areas closer to the activities of the International Swaps and Derivatives Association (ISDA), credit derivatives and synthetic collateralized debt obligations (CDOs), which combine securitization techniques with credit derivatives, have shown spectacular growth since the late 1990s as well. According to the Triennial Survey of the Bank for International Settlements (BIS), the credit derivative market which was 108 billion dollars in 1998 (outstanding notional amounts), expanded more than 6 times to 693 billion dollars by 2001. The ISDA's most recent survey for year-end 2002 puts outstanding notional volume at over 2 trillion dollars.

II. Benefits of Credit Risk Transfer Instruments

The use of credit risk transfer tools together with securitization techniques can and has opened doors and expanded opportunities for various market participants.

With regard to borrowers, for example, if banks transfer credit risk from their loan portfolio using CLOs to a wider base of investors who themselves do not have the capability to evaluate and lend to individual firms, this can certainly lead to more funding opportunities for corporations. Corporations can also directly securitize quality assets on their balance sheets to obtain funds, delinking their funding costs from their own credit quality.

For investors or risk takers, various credit risk transfer instruments provide a cost-effective way of taking on risks in sectors and geographical areas where they might not have direct access. Securitization products also provide the opportunity to obtain diversification benefits and in many cases provide better returns than traditional straight bonds with similar credit ratings.

Banks can free up their balance sheets by transferring credit risk out of their portfolios, and readjust their risk profiles to better match their business objectives and/or improve their risk diversification. Banks' use of credit derivatives reduces the costs involved with obtaining perfection compared with loan sales while maintaining intact the long-term relationships they have built up with customers.

III. Issues Regarding Credit Risk Transfer Markets

I have spoken about the merits of credit risk transfer instruments. At the same time, some of the new markets such as credit derivatives and CDOs are still on their way to adulthood and need to mature. Recently, Mr. Warren Buffet's comment that "derivatives are financial weapons of mass destruction" has received much attention in the markets as well as in the media. Although I do not necessarily concur with Mr. Buffet's expression, there are some areas where advances are called for. It could be said that the new credit risk transfer instruments such as credit derivatives are at a stage of development similar to where the over-the-counter (OTC) derivatives such as interest rate swaps were in the late 80s and early 90s. At that time, following some high-profile losses stemming from the use of derivatives, there were many comments about the "dark side" of derivatives, and some calls for restrictions and tighter regulation of derivative transactions. However, markets have matured together with the quality of risk management; daily turnover for OTC derivatives markets has reached nearly 1.4 trillion dollars (BIS Triennial Survey, April 2001); and outstanding amounts are close to 100 trillion dollars.

I would like to point out a few items where work is needed before the credit derivatives and their related markets can reach similar levels of development.

First, as we all have come to recognize, the measurement and management of credit risk is much more complicated than market risk, as idiosyncratic factors play a stronger role. In the case of credit portfolios, analyzing the correlation effects adds another thick layer of complexity. When evaluating and pricing CDOs, default correlations are an important factor and it seems many investors have experienced the impact first hand as many CDO tranches were downgraded in 2001 and 2002 following some spectacular failures such as Enron and Worldcom.

One of the driving forces in the expansion of the use of credit derivatives and CDOs has been the combination of regulatory arbitrage and risk management needs. It seems the regulatory arbitrage element is gradually diminishing, especially in North American markets. Unfortunately, here in Japan this still seems to be the main motivator for some institutions. Many of these arbitrage opportunities are likely to cease to exist with the implementation of Basel II, the new capital rules of the Basel Committee on Banking Supervision. It would be unfortunate if these credit risk transfer markets were to shrink before the full risk-management potential of these instruments is fully utilized.

Second, there is room for increased transparency. Due to the nature of the instruments and the fact that many deals are done on a bilateral basis, it is difficult to grasp overall developments in the new credit risk transfer markets. Disclosures by individual institutions on the extent of the use of such instruments and the effects on their risk profiles are also limited. The BIS Committee on the Global Financial System recently released its report entitled "Credit Risk Transfer." A major goal of the Working Group that prepared this report was to analyze the possibility of risk diversification and concentration within the financial system through the use of these transfer instruments. On the one hand, there was the view that credit risk transfer instruments such as credit derivatives have enabled banks to transfer credit risk to a wider range of institutions within the financial system, helping them to better withstand the recent weakness in the global economy. On the other hand, concerns were expressed that credit risk may be concentrating in unexpected places within the system or accumulating at an unsustainable pace. Unfortunately, due to limited information and aggregate data, the results of the research and analysis conducted by the Working Group were inconclusive. This issue is not simply of interest to central banks responsible for financial stability. Enhanced transparency paves the way to better risk management at individual firms, thus contributing to the overall health of the financial system. I am sure ISDA can play an active role here.

Third, legal and documentation risk is another important element in these new markets. ISDA has traditionally taken an active leadership role in reducing legal uncertainty through standard documentation, beginning with the 1987 Master Agreement. In the area of credit risk transfer instruments, the 1999 Credit Derivatives Definitions opened the door to the sharp growth of the credit default swap market, and you have continued to update it in light of various credit events. Last February ISDA published the 2003 ISDA Credit Derivatives Definitions and provided further improvements, reflecting, in the words of Mr. Pickel, ISDA CEO, "changes in industry dynamics over the past three years." At the same time, I am sure that the audience would agree that your work is not finished, and constructive discussions among market participants will need to continue before market practice stabilizes, for example on the restructuring definition debate.

Fourth, certain incentive issues arise with the use of credit risk transfer instruments. These arise because such instruments typically change the underlying borrower/lender relationship, and establish new relationships between lenders that become risk shedders and the new risk takers or protection sellers. These new relationships have the potential for market failure due, for example, to asymmetric information. If the risk shedder-the original lender-has better information about the creditworthiness of its borrowers, it may exploit this at the time of the risk transfer to overstate the credit quality to the risk taker. Conflict of interest may arise in a principal/agent relationship where a bank that securitizes its assets continues to service the underlying loans. These situations are in most cases, as I understand, being effectively dealt with by market wisdom, for example, by the use of rating agency information and by requiring originators of securitization transactions to retain a portion of the first-loss tranche.

The use of ratings has helped in effectively dealing with these incentive issues. At the same time, different issues arise because of the expanded role rating agencies are playing in a territory different from the corporate bond markets that have hitherto been their traditional franchise. Their new role is most typical in the rating of portfolio credit risk transfer instruments. Here, their approach to rating tranches is usually credit-risk-model-based; i.e. quantifying default rates, default correlation among different sets of assets, and granularity effects. In effect, what they are doing is no longer giving traditional credit opinions but much closer to generating mathematical model output. Given their dominant role in certain credit-risk transfer markets, central banks may have to work further to better understand the impact such instruments may have on market participant behavior and market dynamics.

IV. Concluding Remarks

Let me close with two more remarks on credit risk transfer instruments. One is about the future, and the other, about the present. Going forward, these instruments may change the nature of the banking business. The ability to readily take on or shed credit risk opens new opportunities for banks. With the wider use of credit risk transfer instruments, banks might begin to shift from their traditional "originating and holding" approach toward credit risk-extending loans and holding them to maturity-to an "originating and distributing" approach. Rapid IT innovation will further accelerate this process. The absolute size of particular banks' balance sheets will then tell little about the role they play in financial intermediation. This could not only transform the conventional relationship between banks and their clients but may also further blur the distinction between banks and other financial sectors. Indeed, I wonder what the banking sector will look like in ten years. A related question would be whether we have to reconsider the traditional relationship between banks and central banks, at least in some respect. For example, one key function of a central bank in maintaining financial stability is acting as the lender of last resort. Traditionally this has been, in principle, targeted at banks. But given the evolving nature of the banking business accentuated by the ongoing financial globalization and the increase in conglomerate structures, the issue may have to be revisited one day.

Turning, finally, to the current situation of the Japanese financial system, all of us know that both borrowers and lenders are suffering from serious balance sheet problems. Financial institutions and institutional investors are not taking as much risk as they would like to if they had healthier balance sheets. The financial system's ability to carry out financial intermediation is seriously damaged. One manifestation of this is that the market for credit risk transfer instruments remains relatively small. For example, CDO deals in the Tokyo market reached 3 trillion yen in 2002-still less than half the amount of the U.S. The small size of the market together with the evolving nature of these new products limited the price discovery function of the market from developing, which in turn, has put a lid on the growth of the asset-backed securities markets, especially those related to small and medium-sized companies.

As I said at the outset, the Bank of Japan decided the day before yesterday at its Monetary Policy Meeting to examine the possible purchase of asset-backed securities in an attempt to supplement the impaired risk-taking function of the private sector and stimulate the growth of such markets. We hope that an ensuing increase in deals will bring in new investors, by improving the function of the markets. The use of the markets will allow banks to free up some capital, which, in turn, can be used to increase lending. Going further down the road, this could become an impetus for banks to shift from the "originating and holding" approach toward credit risk to the "originating and distributing" approach. Borrowers, especially small and medium-sized companies will benefit from prospective declines in the cost of capital as an increasing number of investors recognize the benefits of risk-pooling and the multi-tranche structure of credit risk transfer instruments.

There is also a merit to the Bank of Japan. The Bank has been massively increasing the supply of liquidity. The monetary base has risen by 50% and bank reserves have quadrupled during the last two years, with no discernible effects on the general price level. One of the major reasons for this has been the constrained ability of the banking system to respond to massive liquidity injection and low interest rates by expanding lending. We seem to be at a point where simple liquidity injection will create only minor effects on the economy. Liquidity injection, in my view, has to be carried out in a way that will address the deep problems of the financial system. Surely, buying corporate debt instruments outright is a very unusual thing for a central bank to do. We think, however, it will serve to mitigate the problems faced by banks, and strengthen the ability of the financial system to carry out intermediation along the lines I have discussed. As a result, the effectiveness of monetary policy will also rise.

Needless to say, we will not buy these instruments indefinitely. Care will have to be exercised so as not to distort market mechanisms. The specific design of the scheme will be determined in a Monetary Policy Meeting to take place in the near future. Meanwhile, we are open to suggestions from professional people such as yourselves about the most effective design for such a scheme. In fact, this is the most important message I wanted to convey to this audience today.

Thank you.