Basel Committee on Banking Supervision The Joint Forum Credit Risk Transfer October 2004 THE JOINT FORUM BASEL COMMITTEE ON BANKING SUPERVISION INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS INTERNATIONAL ASSOCIATION OF INSURANCE SUPERVISORS C/O BANK FOR INTERNATIONAL SETTLEMENTS CH-4002 BASEL, SWITZERLAND Credit Risk Transfer October 2004 Table of contents Report on Credit Risk Transfer: Summary............................................................................... 1 Do the transactions accomplish a clean transfer of risk?..................................................... 2 Do participants understand the risks involved?.................................................................... 3 Are undue concentrations of risk developing? ..................................................................... 4 Financial Stability Implications ............................................................................................. 4 Recommendations ............................................................................................................... 5 Report on Credit Risk Transfer.............................................................................................. 11 1. Background................................................................................................................. 11 2. Trends and Market Developments.............................................................................. 12 3. Extent and Sources of Risk Transfer .......................................................................... 15 4. Risk Management Issues Associated with CRT Activity............................................. 22 5. Outstanding issues ..................................................................................................... 34 Annex 1 The Risks of Credit Portfolio Products..................................................................... 42 1. The mechanics, economics, and risks of CDOs ......................................................... 42 2. The recent evolution of credit portfolio products......................................................... 49 Annex 2 Disclosures on Credit Risk Transfer ........................................................................ 60 1. Disclosure made by banks.......................................................................................... 60 2. Disclosure made by securities firms ........................................................................... 61 3. Disclosure made by insurance companies ................................................................. 62 Annex 3 The Supervisory Approaches for Credit Risk Transfer ............................................ 64 1. Minimum capital requirements .................................................................................... 64 2. Regulatory restrictions and limits................................................................................ 70 3. Reporting requirements, guidelines and supervisory oversight .................................. 73 Annex 4 Members of the Working Group on Risk Assessment and Capital.......................... 77 Report on Credit Risk Transfer: Summary The attached report responds to a request by the Financial Stability Forum (FSF) for the Joint Forum to undertake a review of credit risk transfer (CRT) activity. The report was prepared by the Joint Forum’s Working Group on Risk Assessment and Capital on the basis of a number of interviews and discussions with market participants. The September 2003 FSF discussions noted the importance of considering the financial stability issues that could be associated with CRT activity and highlighted three issues in particular: (1) whether the instruments/transactions accomplish a clean risk transfer, (2) the degree to which CRT market participants understand the risks involved, and (3) whether CRT activities are leading to undue concentrations of credit risk inside or outside the regulated financial sector. Additionally, the FSF asked whether there is a need for enhanced reporting to supervisors and improved public disclosures by regulated institutions, as well as whether there is a need for further information on credit risks that are transferred to non- regulated institutions. These questions are addressed below. The Working Group has undertaken efforts to coordinate with similar projects that have been initiated within the European Union. In particular, the Working Group has benefited from direct participation by individuals closely involved in the efforts of the European Central Bank’s Bank Supervision Committee (BSC) and the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS). The Working Group also has been in contact with a representative of the Committee of European Securities Regulators (CESR) to ensure mutual knowledge of the respective projects. On the basis of these liaison activities, the Working Group believes that the products of these various efforts will be complementary. By way of background, it is clear that credit risk transfer, including such transactions as loan guarantees, has a long history. In recent decades, loan syndication and securitisation activities experienced significant growth. The present report, however, focuses more narrowly on the newest forms of CRT, in particular on those activities associated with credit derivatives. The first credit derivatives transactions took place among a handful of pioneering banks in the early 1990’s, with significant growth occurring since the latter part of that decade. The report concludes that CRT activity (defined as indicated in the context of credit derivative-related transactions) has been developing at a rapid rate characterised by significant product innovation, an increasing number of market participants, growth in overall transaction volumes, and perceived continued profit opportunities for financial intermediaries. The report further concludes that continued development of the CRT market offers potential benefits in the form of more liquid and efficient markets for the transfer of credit risk. In this context, the Working Group believes that the most important high-level issues associated with these developments relate to the need for market participants to continue improving risk management capabilities and for supervisors and regulators to continue improving their understanding of the associated issues. Accordingly, the report contains a series of recommendations for market participants and supervisors in the areas of risk management, disclosure, and supervisory approaches. The recommendations specifically address the additional questions raised by the FSF in relation to reporting and disclosure. The remainder of this summary focuses first on the three specific issues highlighted above. It then briefly discusses some of the financial stability aspects considered in the report and concludes with a summary of the recommendations included in the report. 1 Do the transactions accomplish a clean transfer of risk? In regard to the question of whether credit derivatives transactions achieve a clean transfer of risk, the Working Group believes that credit derivatives have achieved a relatively good record to date. There are several issues to consider. First, there is the question of counterparty risk – will the counterparty to a credit derivative transaction be able to perform on its obligations? Market participants address this risk in several ways. A number of transactions are effectively funded up-front, via issuance of securities, so that the counterparty risk is eliminated. Even in the case of unfunded transactions, frequent marking- to-market with transfer of collateral is common, particularly in relation to inter-dealer transactions and those involving lower quality counterparties. Market participants also stress the importance of proper credit due diligence with respect to credit derivatives counterparties. A second issue in regard to achieving a clean transfer of risk is whether there are legal uncertainties associated with the transaction. Market participants express increasing confidence in the legal status of credit default swaps using industry-standard documentation developed by the International Swaps and Derivatives Association (ISDA). In part, this is based on the performance of such contracts in the context of several high-profile corporate defaults. One of the most challenging issues associated with the development of the ISDA documentation has been the question of whether the contracts should cover restructuring events as well as bankruptcy or other more clear-cut default events. While this issue has generated some controversy among market participants, it has not been perceived to affect the legal standing of the ISDA documentation in a fundamental sense. Another issue in relation to the documentation of transactions is whether the trade documents are matched and confirmed in a timely fashion. While many participants still report higher than desired levels of unmatched confirmations, they are hopeful that recent initiatives for automating credit default swap matching and confirmation processes will help alleviate this concern. In regard to legal risk more generally, market participants are cognizant that legal issues have previously arisen in the broader financial derivatives market in several areas. These include the risk that counterparties did not have the appropriate legal authority to enter into the transactions and the risk that a counterparty or customer may