Credit Risk transfer

OECD-IAIS-ASSALFourth Conference on Insurance Regulation and

Supervision in Latin AmericaPunta Cana, Dominican Republic, May 6th-9th,

2003Jens Verner Andersen

jva@nationalbanken.dk

2

Outline Profile of credit risk transfer market

Incentives for undertaking risk transfers

Financial stability implications

Concluding remarks

3

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

4

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 Protection SellerPremium

Contingent payment on default

5

Credit derivative Volumes – 1996 to 2004

0

1000

2000

3000

4000

5000

6000

1996 1997 1998 1999 2000 2001 2002 2003 2004

Notional value volume Source: 2001/2002 BBA Credit Derivatives Survey

Billion USD

6

Maturity Profile of Market at Trade Inception

0 5 10 15 20 25 30 35 40 45

Over 10 years

5-10 years

5 years

1-5 years

3-12 months

1-3 month

per cent

Source: 2001/2002 BBA Credit Derivatives Survey

7

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

8

Who buys

0

10

20

30

40

50

60

70

Banks

Securities Houses

Hedge Funds

Corporates

Monoline Reinsurers

Insurance Companies

Mutual Funds

Pension Funds

Government/Export agencies

End 1999 End 2001

Per cent

Source: 2001/2002 BBA Credit Derivatives Survey

9

Who sells

0

10

20

30

40

50

Banks

Securities Houses

Hedge FundsCorporates

Monoline Reinsurers

Insurance Companies

Mutual Funds

Pension Funds

Government/Export agencies

End 1999 End 2001 Source: 2001/2002 BBA Credit Derivatives Survey

Per cent

10

Net sale of credit protection

-200

-150

-100

-50

0

50

100

150

200

250

Banks

Securities Houses

Hedge FundsCorporates

Monoline Reinsurers

Insurance Companies

Mutual Funds

Pension Funds

Government/Export agencies

End 1999 End 2001

Billion USD

Source: 2001/2002 BBA Credit Derivatives Survey

11

Factors generating growth- protection buyers Capital optimisation:

Increased focus on capital charges as an integral part of credit lending

Risk/return Improved risk management options:

Sector Geographic

Retain commercial clients: without having negative concentration impacts Preserve relationship discount

Regulatory capital relief

12

Factors generating growth- protection sellers Enhancing yields: Decline in interest rates

across the board in combination with lower supply of sovereigns have increased end-investors’ 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

13

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

14

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)

15

Financial stability implications Regulatory arbitrage

Regulatory Capital Accounting

Learning curve risks 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

16

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

Financial stability implications (cont’d)

17

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