Transcript Risk transfer mechanisms

Credit Risk transfer
OECD-IAIS-ASSAL
Fourth Conference on Insurance Regulation and
Supervision in Latin America
Punta Cana, Dominican Republic, May 6th-9th, 2003
Jens Verner Andersen
[email protected]
Outline

Profile of credit risk transfer market

Incentives for undertaking risk transfers

Financial stability implications

Concluding remarks
2
Introduction



Credit risk transfer mechanisms comprise a wide
group of credit derivatives
Transfer risks embedded in credit lending
(corporate loans or bonds)
Change financial sector landscape: Bridging
bank and insurance activities with capital
markets
3
Introduction (con’d)
- building blocks



Credit derivatives isolate an entity’s/pool of
credit’s risks
risks include bankruptcy, failure to pay and
restructuring of bonds or loans
Liquid standardised markets – governed by 1999
ISDA Credit Derivatives definitions
Reference entity
Protection Buyer
Premium
Protection Seller
Contingent payment on default
4
Credit derivative Volumes –
1996 to 2004
Billion USD
6000
5000
4000
3000
2000
1000
0
1996
1997
1998
1999
2000
2001
2002
2003
2004
Source: 2001/2002 BBA Credit Derivatives Survey
Notional value volume
5
Maturity Profile of Market at
Trade Inception
1-3 month
3-12 months
1-5 years
5 years
5-10 years
Over 10 years
0
5
10
15
20
25
30
35
40
per cent
Source: 2001/2002 BBA Credit Derivatives Survey
6
45
The Product Universe
Single name credit default swaps
Portfolio/CLOs
Credit-linked notes
Total return swaps
Asset swaps
Credit spread options
Basket products
Source: 2001/2002 BBA Credit Derivatives Survey
7
Who buys
Per cent
70
60
50
40
30
20
10
0
ks
n ds
nd s
r er s
nds
ci es
n i es
u ses
at es
u
u
u
r
u
n
a
o
s
F
Ban
F
F
o
e
p
H
n
l
p
a
m
s
ei
ag
ge
on
Cor
utu
or t
r it ie
e Co
en si
Hed
ne R
u
p
c
M
i
P
l
c
x
n
o
e
/E
S
n
ra
ent
Mo
In su
m
n
r
e
End 1999 End 2001
Gov Source: 2001/2002 BBA Credit Derivatives Survey
8
Who sells
50
Per cent
40
30
20
10
0
s
s
s
s
rs
es
es
ds
ses
Fu n d
Ban k
su r e
Fun d
en ci e
o r at
pan i
Ho u
l Fu n
n
g
p
n
e
i
a
s
m
r
a
o
g
e
e
u
i
o
o
i
t
t
s
R
d
t
C
r
C
ri
He
po
Mu
Pen
o lin e
ance
Secu
nt /Ex
e
M on
In su r
m
rn
Gove
Source: 2001/2002 BBA Credit Derivatives Survey
End 1999 End 2001
9
Net sale of credit protection
Billion USD
250
200
150
100
50
0
-50
-100
-150
-200
s
s
s
s
rs
es
es
es
ses
su r e
Fu n d i o n Fun d
Ban k
en ci
Fu nd or po r at
p an i
Ho u
n
l
g
i
e
a
m
s
a
e
g
u
e
o
R
t
i
t
C
C
or
r it
Hed
Mu
Pen s
o l i n e su r an ce
/Exp
n
Secu
t
o
n
e
M
In
er nm
Gov Source: 2001/2002 BBA Credit Derivatives Survey
End 1999 End 2001
10
Factors generating growth
- protection buyers

Capital optimisation:



Improved risk management options:



Sector
Geographic
Retain commercial clients:



Increased focus on capital charges as an integral part
of credit lending
Risk/return
without having negative concentration impacts
Preserve relationship discount
Regulatory capital relief
11
Factors generating growth
- protection sellers




Enhancing yields: Decline in interest rates
across the board in combination with lower
supply of sovereigns have increased endinvestors’ demand for new instruments.
Return on Capital: Deploy capital more efficiently
- obtain higher risk adjusted returns.
Excess capital in the insurance sector
Leverage expertise and brand in related
businesses
12
Value added in insurance
companies

Separating value creation into two entities:



Insuring risks: Issuing insurance contracts that more
than cover the associated production costs, including
capital cost.
Investing cash from premiums until claims are paid:
Achieving an investment result that beats the
benchmark on a risk-adjusted basis.
Insurance companies focus on shareholder
value by:



Managing capital more efficiently: constrain capital to
business generating sufficient profit.
Risk transfer techniques: Credit enhancement is
innovative use of surplus capital.
Apply basic underwriting skills in related areas
13
Factors generating growth
- market factors




New product types - Not only a hedging device
Structured products enhance liquidity in credit
derivative markets
Broader investor interest
Continuous price setting in largest credit types in
electronic systems (eg. Bloomberg)
14
Financial stability implications

Regulatory arbitrage




Learning curve risks


Regulatory
Capital
Accounting
Complex business on the borderline between banking
and insurance: Do market participants understand
risks?
Risk management



Adequate pricing and proper valuation are demanding
but important when risks crystallise.
Counterpart exposures may still exist
An integral part of corporate culture
15
Financial stability implications
(cont’d)

Transparency and disclosure




Lack of transparency
Rating agencies play a special role
Fitch Ratings special report: Global Credit Derivatives:
Risk Management or Risk
Consumer protection issues


New types of risks have been transferred to small
investors in CIS type schemes, variable annuities, and
DC pension schemes
Pay more attention to aspects related to final
consumers
16
Concluding remarks

Potential benefits from credit derivatives:



Risk transfer markets offer opportunities for improved
risk management.
Facilitate more manageable credit- and insurance
cycles as deployment of capital is improved.
Depends on management of new risks



Capital market innovation is a challenge for users and
authorities.
Capital market integrity issues related to accounting,
capital and consumer protection
Enhanced transparency is needed
17