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Credit Risk transfer

This paper discusses the profile of credit risk transfer market, incentives for undertaking risk transfers, and the financial stability implications. It also highlights the importance of transparency and disclosure in credit derivatives markets.

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Credit Risk transfer

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  1. 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 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 Seller Premium Contingent payment on default

  5. Credit derivative Volumes – 1996 to 2004

  6. Maturity Profile of Market at Trade Inception

  7. The Product Universe

  8. Who buys

  9. Who sells

  10. Net sale of credit protection

  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. 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

  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

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