Towardmorereliablebankingmodelthroughmoreefficient creditrisktransfer

By\AlaaM.EzzalarabMBA,LLM

Theprevalenceoftheoriginateanddistributemodeloverthepasttwentyyearsled toasignificantgrowthofthestructuredfinancemarket(ECB2008).Usingthecredit risktransfer(CRT)instrumentsresultedinashiftinbanksmodel"originatetohold" to "originate to distribute" (Knight 2008). The range of CRT instruments have widened considerably, during the last decade (Kean r& Fermor 2002). However, techniques for transferring credit risk, such as financial guarantees and credit insurance, have been a longstanding feature of financial markets (GCFS 2003). It was argued that Credit Risk Transfer (CRT) leads to a desirable redistribution and betterdiversificationofcreditrisks(AllenandGale,2005). In essence, the credit risk could be defined as the risk that an obligor defaults (borrower, issuer, counterparty) (Kean & Fermor 2002). CRT instruments typically pass on credit risk from the lenders to risk buyers. Hence, such instruments may change the relationship between borrowers and lenders and establish new relationships between them (GCFS 2003). As a result, CRT has the potential to change the key roles; originally, banks play, and are likely to continue to play, as lenders and liquidity providers. So, in order to figure out an appraisal portrait of "originatetodistribute"model,itishelpfultoillustratetheCRTbackground,aswell as the characteristics of the CRT instruments. Then, it is crucial to understand the natureandlimitsoftheirperformanceimpactsonboththebanksandthemarkets, hence,tocrystallizethedevelopmentprospectswhicharerequiredformorereliable bankingmodel. Initially,CRThasgrownduetocertainreasons,like:greaterfocusbybanksandother financial institutions on risk management; a more rigorous approach to risk/return judgmentsbylendersandinvestorsandanincreasingtendencyonthepartofbanks to look at their credit risk exposures on a portfoliowide basis; efforts by market intermediaries to generate fee income; a generally low interest rate environment,
1

whichhasencouragedfirmstosearchforyieldpickupthroughbroadeningtherange of instruments they are prepared to hold; and arbitrage opportunities arising from differentregulatorycapitalrequirementsappliedtodifferentkindsoffinancialfirm (CGFS2003). In response to that, CRT instruments have proliferated through manyformats. The instruments can be classified according to whether they transfer credit risk associated with an individual borrower (single name) or a number of borrowers (portfolio),oreven,directlybetweenrisksellerandriskbuyerorindirectlythrougha specialpurposevehicle(SPV).Further,thecreditcouldbetransferredeitherthrough transferring the underlying asset, or rather through transfer of the credit risk synthetically using credit derivatives. Also, the classification could be based on whether they are funded or not. For instance, the sale of a loan is a funded risk transfer however, insurance contracts, transfer credit risk but without providing fundsatthetimetheriskistransferred(Kean&Fermor2002). In addition to its classification, the other aspect of the CRT instruments characteristics is their valuation approach. The single name products like CDSs (Credit Default Swaps), are directly observable in the market, however, in other cases, no market exists and prices have to be derived indirectly by "replication", basedonadecompositionoftheCRTinstrumentintocomponentsforwhichprices doexist,orbyapplicationofamodel.Incontrasttothat,creditriskmodelingplaysa majorroleinthepricingoftranchesofmanyportfolioCRTinstrumentssuchasmore exoticABSs(AssetBackedSecurities)andCDOs(Collateralizeddebtobligation)(CGFS 2003). Duetotheirdiversificationandwiderangedcharacteristics,theCRTinstrumentshad a remarkable impact on the banks financial management. They could enhance the banks' lending capacity, however, affect their incentive to monitor the loans they originated,raisethemoralhazardandadverseselectionrisks,andevensometimes, increasemarket,liquidity,fundingaswellassolvencyrisk. Basically, the CRT instruments have resulted inaugmenting the lending capacity of thefinancialinstitutions.(Goderis,Marsh,Castello&Wagner2007)concludedthat banks that adopt advanced credit risk management techniques see a permanent 50% increase in their target level of loans. Further, (Brewer, Minton and Moser 2000)statedthatUSbanksthatareactiveparticipantsininterestratederivatives markets, can make more loan than banks that are not. (Cebenoyan and Strahan 2004)showthatactive(creditrisk)managementintheloansalesmarketenables bankstogetintogreaterloanslevels,alongwithholdinglesscapitalthanbanksthat arelessactiveinloansales.Inaddition,(Froot,ScharfsteinandStein1993)aswellas (FrootandStein1998)presentedmodelsinwhichactiveriskmanagementcanallow bankstoenergeticallydeveloptheirloanportfolioswhileholdinglesscapital.Adding tothat(WagnerandMarsh2006)providedatheoreticalmodelinwhichabankthat hasengagedincreditportfoliodiversificationactivitiesreducestheriskpremiumit chargesonloansandhenceincreasesitslendinglevels.
2

 However,CRTinstrumentsemphasizedthereducedmonitoringincentivesofbanks, once a loan has been transferred to a third party (Pennacchi, 1988; Gorton and Pennacchi, 1995). Also, recent empirical findings suggest that there has been an expansion of low quality loans, whereas (DellAriccia, Igan, and Laeven (2008) document a decline in loan denial rates, which they interpret as a decrease in lending standards. (Purnanandam 2009) confirmed by evidence that the lack of screening incentive created by the separation of origination from the ultimate bearer of the default risk, has been a contributing factor to the current mortgage crisis. Nevertheless, the report of European central bank in 2008 on the incentive structure of the originateanddistribute model, concluded that a blackandwhite viewoftheoriginateanddistributemodelshouldnotbeadapted,inasensethatin somecases,suchastheUSsubprimemortgagemarkets,misalignedincentiveshave clearly played an important role, while in other markets, such as credit card securitisation, where the participants have acknowledged potential conflicts of interestandhavetakenmeasurestoalleviatetheproblems. Asamainconsequenceofdiminishingtheincentivestomonitor,theCRTpractices raiseseveralmoralhazardandadverseselectionquestions.(Berndt&Gupta2008) foundthatborrowerswithanactivesecondarymarketfortheirloansunderperform theirpeersbyabout9%peryearintermsofannual,riskadjustedabnormalreturns, overathreeyearperiodsubsequenttotheinitialsaleoftheirloans.Byexamining thelongruneffectsoftheexistenceofthesyndicatedloanmarketontheborrowing firms, they found that the borrowers with an active loanmarket suffer a valuation loss of about 15% of the value of their Total Assets over a three year period compared to their peers. Such results were attributed to two reasons, first, banks mayindeedbesellinglemonsbasedontheirunobservableprivateinformationabout the borrower. And, second, borrowers might suffer due to their diminished relationshipwithbanks,sinceitremovesthedisciplineofbankmonitoring. Adding to that (Llewellyn 2009) lengthened the shadow of doubt over CRT instruments capacity to reduce the overall risks of the banks business. In that, he concluded that credit risk shifting instruments has both riskshifting and risk changing properties. In specific, the financial crisis has revealed two major implications of credit riskshifting instruments: (1) in many cases such risk was not shiftedasmuchasbanksthoughtwouldbethecase,and(2)evenwhencreditrisk wasshifted,thiswassometimesatthecostofincreasingmarket,liquidity,funding andultimatelysolvencyrisk.Morespecifically,thecreditriskthatisinitiallyshifted mayinvoluntarilycomebackontothebalancesheetoftheoriginatingbank.Asan example, the Northern Rock was exposed to liquidity risk because its securitizing SpecialPurposeVehiclecouldnotrolloverinthewholesalemarketsitsmaturing shortterm borrowings that were used to fund the acquisition of longterm mortgages. This liquidity risk, in turn, was quickly transformed into a structural funding risk (as alternative sources of funding were unavailable), which was ultimatelytransformedintoasolvencyrisk.
3

Besideitsimpactonthebanksfunctioning,CRThas,also,asignificantimpactonthe marketsfunctioning,liquidity,transparencyaswellasriskconcentration.However, theroleoftheCRTinthemarketissubjecttothetypeofinformationuponwhich the loans are based, the regulatory and accounting treatment as well as the competitionlevelsinthemarket.Addingtothat,theCRTroletakesshapebasedon theinterrelationbetweenmarketsaswellastheassessmentefficiencyoftherating agencies. RecognizingthevitalroleoftheCRTinthemarkets,thereportofBaselCommittee onbankingsupervisionin2005,mentionedthatCRTisanefficienttoolinreducing risk concentrations as well as fostering more liquid and transparent markets for creditriskgenerally.However,someelementsoftheCRTmarketappeartobehighly concentrated,whichmightgiverisetomarketdisruptionifthefirmsconcernedwere to come under pressure. Further, (Weber 2009) stated that the most prominent shortcomings revealed by the financial crisis fall within the scope of credit risk transfer and the expansion of the originate to distribute business model that accompaniedit. As an essential factor, (Hakenes, Schnabel 2009) concluded that the functioning of CRTmarketsdependscruciallyonthetypeofinformationonwhichbankloansare based.Ifloansaregrantedonthebasisofpubliclyobservableinformation,atransfer of credit risk works smoothly, and, there is no moral hazard problem at the originatingbank.If,however,loansaregrantedonthebasisofprivatelyobservable information, the transfer of credit risk is hampered by problems of asymmetric information,andmayleadtoamoralhazardproblemintheoriginationofloans. Further, the regulatory framework has crucial influence. The functioning of CRT marketsisaffectedwiththedifferenttreatmentoftheinstruments.Still,reflecting market valuations in published accounts is a controversial issue concerning the accounting rules. Furthermore, the situation could be exacerbated due to the fact thatCRTexposesmoresharplydifferencesinregulatorytreatment. Addingtothat,thefunctioningofCRTmarketsissubjecttotheircompetitionlevels. Asevidence,(DellAriccia,Igan,& Laeven(2008)showthat loandenialratesinthe subprimesegmentdecreasedmoreinareaswithhighlycompetitivebankingmarkets andthatthemarketentryofnewfinancialinstitutionsinducedafurtherdecreasein lending standards. (Hakenes & Schnabel 2009) show further that competition generally reinforces the positive effects of credit risk transfer. The higher competitioninthebankingsector,thebetteristheaccesstocredit.However,under privateinformation,highercompetitionleadstoanexpansionofnegativeNPVloans, whichinthelimitoffsetsthewelfaregainsfromCRTcompletely. Notwithstanding, the CRT instruments impact could not be fully comprehended without figuring out the interrelated impacts between the different markets. (Llewellyn2009)statedtheexpandinginterrelationbetweentheCRTmarketandthe other markets, including linkages with both bond and equity markets. In that, an
4

eventinonemarketwillhaveaspillovereffectintotheCRTmarket.Insupportingto that,(Allen&Carletti2005)concludedthatCRTcanleadtocontagionbetweenthe two sectors, hence increase the risk of crises and lead to a Pareto reduction in welfare,whentheyfaceidiosyncraticliquidityriskandhedgethisriskinaninterbank market.Usingamodelwithbankingandinsurancesectors,itwasshownthatcredit risktransfercanbebeneficialwhenbanksfaceuniformdemandforliquidity. Inparallelwiththeregulationrole,ratingagencieshaveacriticalroleinvariousCRT marketsandtheimplicitrelianceontheriskassessmenttechniqueswhichtheyuse (CGFS 2003). The financial crisis has raised questions about the effectiveness of CreditRatingAgencesassessmentofrisksinratingcomplexfinancialproducts(CGFS 2008). In specific, the deficiencies, which are revealed by the financial crisis, concern insufficient capital backing for securitizations, inadequate risk management within financial institutions in addition to a lack of transparency in the whole transfer process.Consequently,thenecessarymodificationsaffectallthreepillarsofBaselII which are capital adequacy requirements, centralized supervision and market discipline(Decamps,Rochet,Roger2002). Inthelightofinsights,theBaselCommitteeonBankingSupervisionhasresponded promptly and many reforms are already under way. More specifically, the capital requirements for securitisations have already been raised and stricter disclosure requirementshavebeenpublished.Bothmeasureswereplannedtobeimplemented in 2010. Moreover, the Basel Committee has strengthened the guidelines for the supervisory review process under pillar two of the Basel framework and thus addressed key lessons of thecrisiswith regard to governance, the management of riskconcentrations,stresstesting,valuationpracticesandexposurestooffbalance sheetactivities(Weber2009). In line with that, Llyod Blankfein, the chairman of Goldman Sachs, (Biggest investment bank worldwide) mentioned before the investigation Congressional Committee, on 28 April 2010 that Goldman Sachs, is in supporting financial regulatoryreform,basedonclearinghousesforeligiblederivativesandhighercapital requirementsfornonstandardinstruments. Adding to that, it becomes a requirement to have convergence in the accounting rules. However, the required convergence becomes more essential due to the valuation challenges, generated by the enhanced risk transfer capability in conjunctionwithfinancialengineeringtechniques.Whereas,suchtechniquescanget out with financial instruments, such as certain CDO tranches, with novel risk characteristics which do not easily fit into conventional instrument classes. The monitoringoffinancialmarketstoidentifyarbitrageactivitiesshouldcontinuetobe an important source of information for bank and insurance regulators in detecting remainingincentiveincompatibilities.Morespecifically,amorequalitativeapproach, beyondthequantitativecapitalrules,maybeneeded(CGFS2003)
5

 In integration with that, it becomes important that rating reports should provide bettercomparisonsofriskwithinandacrossclassesofdifferentstructuredproducts. Also,ratingagenciesshouldbetterreportonthefrequencyofratingupdates.More userfriendlyaccesstotheirmodelsanddocumentationshouldbeprovided.Inthat, such models and documentation should facilitate the conducting of what if? analysis or stress tests by users on key model parameters as well as the economic assumptionsunderlyingtheratingofthestructuredproducts(CGFS2008). Allinall,the"originatetodistribute"isessentialforbetterfunctioningofbothbanks and markets. The recent and undergoing reform could be helpful to alleviate the pitfalls of the model. Further, it is expected that the trend of instruments standardization with welltested and conservative structures will gain momentum (ECB2008).However,thewatchdogs,bothgovernmentalandinternational,should work through unified efforts to enhance their institutional capacity for providing more smart monitoring process. In order to get more reliable banking model, the foreseeing process of the new structures impacts on the banking environment dynamicsshouldprovidemorereliableleadingindicators. References 1 Allen,Franklin.Carletti,Elena."Creditrisktransferandcontagion",2005 2 Allen,F.,andD.M.Gale(2005):SystemicRiskandRegulation,inTheRisks ofFinancialInstitutions,ed.byM.Carey,andR.M.Stulz,pp.341375.The UniversityofChicagoPress. 3 Basel Committee on Banking Supervision (2005): Credit risk transfer, March,providesanoverviewofthetradingofcreditrisk. 4 Berndt, Antje. Gupta, Anurag. "Moral hazard and adverse selection in the OriginatetoDistributeModelofBankCredit",2008 5 Brewer, E Milton, B A Moser, J T (2000) Interestrate Derivatives and Banklending.JournalofBankingandFinance24,353379. 6 Cebenoyan S., and Strahan P.E., 2004, Risk Management, Capital Structure andLendingatBanks,JournalofBankingandFinance,28,1943 7 Committee on the Global Financial System (CGFS). "Credit Risk Transfer", 2003 8 CommitteeontheGlobalFinancialSystem(CGFS),paperno.32." Ratingsin structured finance: what went wrong and what can be done to address shortcomings?",2008 9 DellAriccia, G., D. Igan, and L. Laeven (2008): Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market, IMF Working PaperWP/08/106. 10 EuropeanCentralBank(ECB)"Theincentivestructureofthe'Originateand distribute',2008 11 Froot,KScharfstein,DStein,J(1993)RiskManagement,Coordinating CorporateInvestment,andFinancingPolicies.JournalofFinance48,1, 629658.
6

12 Froot,KStein,J(1998)RiskManagement,CapitalBudgeting,andCapital Structure Policy for Financial Institutions: an Integral Approach. Journal of FinancialEconomics47,1,5582. 13 Gorton,G.B.,andG.G.Pennacchi(1995):BanksandLoanSalesMarketing NonmarketeableAssets,JournalofMonetaryEconomics,35,389411. 14 Goderis, Benedikt. Marsh, Ian W. Castello, Judit Vall. Wagner, Wolf. "Bank behaviourwithaccesstocreditrisktransfermarkets",2007 15 Hakenes, Hendrik. Schnabel, Isabel. "Credit Risk Transfer and Bank Competition",2009 16 Kean,Sue.Fermor,Michael."CreditRiskTransferthroughCreditDerivatives andregulatoryissues",2002 17 Knight, Malcolm D. "Some reflections on the future of the originateto distribute model in the context of the current financial turmoil", Speech by Mr Malcolm D Knight, General Manager of the BIS, at the Euro 50 Group Roundtableon"Thefutureoftheoriginateanddistributemodel",London,21 April2008. 18 Llewellyn, David T." Financial innovation and a new economics of banking: Lessonsfromthefinancialcrisis",2009 19 Pennacchi,G.G.(1988):LoanSalesandtheCostofBankCapital,Journalof Finance,43(2),375396. 20 Purnanandam,Amiyatosh."OriginatetoDistributeModelandtheSubprime MortgageCrisis,2009 21 Wagner, W Marsh, I W (2006) Credit Risk Transfer and Financial Sector Performance.JournalofFinancialStability2,173193. 22 Weber,Axel"Thefutureofbankingregulation",2009 PaperID: paper ID: 6642341