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Basel Committee on Banking
Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
V. Recommendations and policy options to broaden the scope of
regulation to hedge fund activities
Hedge funds have been clearly identified as one of the most
significant group of institutions in the “shadow” banking
system, notably by the G-20.
Measures have already been
taken or are under discussion to supplement the traditional
indirect approach to regulate hedge funds (ie where supervisors
regulate other entities’ interactions with hedge funds).
These measures would increase direct regulation of hedge
funds or their managers and may help to mitigate their risks.
In June 2009, IOSCO made a significant contribution at the
international level regarding regulation of hedge funds with the
publication of its report titled Hedge Fund Oversight: Final
Report.
The following Joint Forum recommendations and
policy options fully take into account IOSCO’s work to avoid
duplication of efforts and to leverage analysis already
conducted.
The Joint Forum fully supports the six
high-level principles on the regulation of hedge funds and/or
hedge fund managers/advisers (or hedge fund operators) as set
forth by IOSCO.
Prime brokers and banks that provide
financing and other services to hedge funds are subject to both
conduct of business and prudential regulations in all
jurisdictions.
This regulation includes standards on
risk management of counterparty risk exposures.
In fact,
as mentioned, the prevailing indirect approach to addressing
risks posed by hedge funds has, thus far, been through
regulation of relevant counterparties.
Therefore,
although counterparties and investors can be a transmission
mechanism for financial distress, the Joint Forum in this report
focuses on existing gaps in the direct prudential regulation of
hedge fund operators and relevant hedge funds.
Because
most of the concerns relating to hedge fund activities are
shared with other categories of market participants, such as
similar types of less-regulated investment vehicles and/or their
operators, the Joint Forum’s recommendations and policy options
have a functional tenor.
They apply to all pools of
capital and to managers/advisers who engage in activities posing
risks substantially similar to hedge funds, regardless of how
they are denominated or qualified domestically.
This
approach is aimed at encompassing existing differences in the
definition of hedge funds at the national level, or even the
lack of definition, and at avoiding regulatory arbitrage.
Recommendation n° 10:
Supervisors should introduce and/or strengthen (in view of the
risk posed) appropriate and proportionate minimum risk
management regulatory standards for hedge fund operators.
If necessary, supervisors should be given the authority to
do so.
The minimum risk management regulatory standards
should be scaled to the size and complexity of the funds ; in
particular, supervisors should strongly consider adopting the
following standards:
Maintenance of
an appropriate risk management policy.
Hedge fund
operators should be required to develop and maintain
appropriate, proportionate, and documented risk management
policies to identify, measure, monitor, and manage all risks
stemming from the activity of each managed hedge fund,
consistent with its intended risk profile.
Appropriate
reporting lines should be established to ensure frequent and
timely reporting to senior management about the actual level of
risks.
Establishment of an
effective risk management function.
Risk
management policies and procedures should be implemented through
the establishment of an effective risk management function
within the hedge fund operator, appropriate to their respective
risk profile.
The risk management function should be
hierarchically and functionally independent from the hedge fund
management functions.
Where the establishment of a
separate risk management function would be disproportionate to
the nature, scale, or complexity of the hedge fund operator’s
activity, the hedge fund operator should establish appropriate
safeguards against conflicts of interest and be able to
demonstrate that the risk management process is consistently
effective.
Management of liquidity
risk and stress tests.
The operator should be
required, for each hedge fund it manages, to employ appropriate
liquidity risk management systems.
This is to ensure
that the liquidity profile of the hedge fund’s investments
complies with its obligations and the redemption policy that has
been disclosed to its investors, including possible gates and
suspensions.
The hedge fund operator should be required
to conduct stress tests to assess and monitor the liquidity risk
(and possibly other risks) under normal and exceptional
circumstances for consistency with the funds’ liquidity profile.
Conditions for delegation of
activities relating to risk management.
When a
hedge fund operator delegates the performance of risk management
to a third party, the hedge fund operator should remain fully
responsible for the selection of the third party and for the
proper performance of the risk management activity.
The
delegation should not prevent effective supervision by the
relevant authorities of the adequacy of the risk management
process.
Need for adequate and
effective risk measurement methods and techniques.
Hedge fund operators should be required to adopt adequate
and effective arrangements and techniques for risk measurement
to ensure that, for each hedge fund they manage, the risks of
the positions and their contribution to the overall risk profile
are accurately measured to ensure consistency with the fund’s
risk profile.
These methods should include both
quantitative measures and qualitative techniques aimed at
measuring the effects of market risk, credit risk (including
issuer risk and counterparty risk) and liquidity risk.
Recommendation n° 11:
Supervisors should impose reporting requirements on hedge fund
operators to identify current or potential sources of systemic
risk and to enable cross-sectoral monitoring of systemically
important hedge funds.
If necessary, supervisors should
be given the authority to do so.
Meaningful information
should be reported to supervisors to enable them to monitor,
evaluate, and exchange information on systemic risks on a
cross-sectoral basis.
To this end, the Joint Forum
supports the IOSCO initiatives to develop appropriate reporting
requirements.
Recommendation n° 12:
In view of the operational risks posed and in order to allow for
orderly winding down of a fund operator in the event of
bankruptcy, supervisors should impose minimum initial and
ongoing capital requirements on operators of systemically
relevant hedge funds.
If necessary, supervisors should
be given the authority to do so.
There should be initial
and ongoing capital requirements for relevant hedge fund
operators as a condition for registration and ongoing
supervision.
Such requirements could be designed to
absorb losses arising from operational failures and may allow
for orderly winding down of a fund operator in the event of
bankruptcy.
The level of minimum capital standards should
be enough to allow an orderly liquidation of or transfer of
funds managed by a failing hedge fund operator and take account
of the obligations of the operator.
Operators should be
subject to timely regular reporting to their supervisors in
order to allow supervisors to monitor on an on-going basis the
capital adequacy.
Options to be
considered for systemically relevant pools of assets
In addition to the prior recommendations, other options set
forth below may help mitigate any risks posed by hedge funds and
comparable pools of assets.
The Joint Forum has not
reached a consensus on the following policy options but has
nevertheless decided to include them in the interest of
providing policymakers with regulatory actions that are
supported by some but not all Joint Forum members.
The
following options are aimed at addressing the macroprudential
risks, particularly procyclicality and leverage-related risks,
posed by a pool of assets itself (as opposed to its operator),
where the size or other characteristics of the pool are deemed
to make it systemically relevant.
The identification of
the criteria to assess the systemic importance of a pool of
assets, such as a hedge fund, should take into account the work
done by the International Monetary Fund, the Bank for
International Settlements, and the Financial Stability Board.
Haircuts and margin requirements:
To mitigate counterparty credit risk, supervisors could require
hedge funds to provide collateral in excess of the value of the
funds borrowed.
This option would limit leverage only if
generally imposed by all counterparties, since otherwise the
collateral for one counterparty could be financed by borrowing
from the other.
Imposing closed-end
form/redemption gates: To limit excessive funding
liquidity risks, supervisors could require hedge funds that
significantly invest in illiquid assets (eg more than a certain
percentage of their portfolio) be set up as closed-end funds or
to adopt adequate gating structures in order to address
liquidity mismatches.
Risk-independent
leverage requirements: To avoid excessive risk-taking,
supervisors could impose direct and simple caps on leverage,
including from exposures arising from derivatives and/or
financing.
Risk-based capital or
leverage requirements: Regulators could limit leverage,
including from exposures arising from derivatives and/or
financing, specified as a function of risk weighted assets, so
that limits become more stringent when assets are riskier.
Risk management procedures for the
timely delivery of financial instruments. Short selling
is a legitimate trading technique. But hedge fund operators that
engage in short selling should be required to ensure that each
hedge fund they manage, irrespective of the hedge fund’s
domicile and legal nature, is organised and operated to comply
with applicable regulatory requirements to avoid market
disruption.
To promote this goal, hedge fund operators
engaging in short selling should be required to adopt procedures
that ensure timely delivery of the short sold financial
instruments (eg by adhering to a master agreement that governs
borrowing/lending of securities).
Potential advantages of options: These options might be
used as tools for imposing limits to the level of leverage and
preventing excessive risk taking by hedge funds.
This
approach would promote a more level playing field between hedge
funds and other more traditional regulated market participants
that pose similar prudential risks, for example, operators of
other types of collective investment undertakings and bank
trading desks.
Potential
disadvantages of options: Setting ex ante leverage or
liquidity caps or leverage requirements could be an extremely
difficult and complex task, considering the different strategies
and activities of hedge funds.
The risk is that setting
arbitrary limits could cause market distortion and would almost
certainly be gamed.
Imposition of limits beyond those
essential to mitigate excessive systemic risk would unduly limit
investor choice.
Outright regulation might also be
expected to increase moral hazard or shift the activity to any
jurisdiction that imposes less hedge fund regulation.
In
this context, international regulatory and supervisory
convergence remains critical.
Chapter 5
Credit Risk Transfer Products
I. Introduction
One of the factors contributing to the financial crisis was
the inadequate management of risks associated with various types
of products designed to transfer credit risk.
This
shortcoming resulted in severe losses for some institutions.
Such products can result in transferring risks not only
within, but also outside the regulated sectors.
This
report focuses on two credit risk transfer products that
evidenced major regulatory gaps in regulation.
The
products are:
• Credit default swaps (CDS); and
•
Financial guarantee (FG) insurance.
CDS and FG insurance
are products that provide protection against identified credit
exposures.
Since the provider of that protection may
have to make a payment on the protection contract, these
products create a new source of credit exposure.
Buyers
of credit protection therefore need to maintain and enforce
sound counterparty credit risk management practices.
While CDS and FG insurance products have quite different legal
structures, they perform similar economic functions.
The
Joint Forum’s analysis identified the following issues as common
to both CDS and FG insurance products.
Each contributed
to the recent crisis or poses cross-sectoral systemic risk.
• Inadequate risk governance:
Sellers of credit protection did not and often could not (given
their existing risk management infrastructure) adequately
measure the potential losses on their credit risk transfer
activities.
This was generally true in the CDS market
and to a lesser extent in the regulated FG insurance market
(where there is at least some financial reporting required by
statute).
Buyers of protection did not properly assess
sellers’ ability to perform under the contracts, and they
permitted imprudent concentrations of credit exposures to
uncollateralised counterparties.
•
Inadequate risk management practices: Poor management of
large counterparty credit risk exposures with CDS and FG
insurance transactions contributed to financial instability and
eroded market confidence. CDS dealers ramped up their portfolios
beyond the capacity of their operational infrastructures.
• Insufficient use of collateral:
The absence of collateral posting requirements for highly
rated protection sellers (eg AAA-rated monoline firms) allowed
those firms to amass portfolios of over-the-counter (OTC)
derivatives, and FG insurance contracts - and thus create for
their counterparties excessive credit exposures - far larger and
with more risk than would have been the case had they been
subject to normal market standards that required collateral
posting.
• Lack of transparency:
The lack of transparency in the CDS and to a lesser extent in
the FG insurance markets made it difficult for supervisors and
other market participants to understand the extent to which
credit risk was concentrated at individual firms and across the
financial system.
Market participants could not gauge
the level of credit risk assumed by both buyers and sellers of
credit protection.
• Vulnerable market infrastructure:
The concentration of credit risk transfer products in a small
number of market participants created a situation in which the
failure of one systemically important firm raised the
probability of the failure of others.
II. Background
There is broad agreement that credit risk transfer exposures
should be subject to sound counterparty credit risk management.
This report focuses on areas not already specifically
addressed by other international bodies and on areas where
additional input on previous recommendations would be
beneficial.
In addition, this report attempts to
consolidate and emphasise recommendations that have been made in
other fora.
Credit risk transfer products contributing to
the crisis included OTC derivative instruments as well as more
complex instruments, such as collateralised debt obligations
(CDO) holding asset-backed securities and arbitrage or hybrid
asset-backed commercial paper conduits, the risks of which were
highlighted in two earlier Joint Forum papers on credit risk
transfer.
While investors suffered major losses on such
products, this paper focuses on CDS and FG insurance products
because they are the building blocks of the credit exposures
that contributed to the crisis.
For example, CDOs often
used CDS products as the source of the credit risk in their
structures.
Some of the factors contributing to the risk
management failures associated with CDOs, including overreliance
on third-party credit ratings and inappropriate regulatory
capital requirements, are already being addressed by the Joint
Forum and by financial sector supervisors and regulators.
Likewise, this report does not focus on other long-standing
forms of credit risk transfer, such as loan guarantees,
syndications or traditional securitisation activities.
The Joint Forum believes issues associated with such activities
have been addressed in other international fora and are
relatively well-understood.
For example,
the Joint
Forum’s parent committees are addressing weaknesses identified
with securitisation.
This report builds on the IOSCO’s
recommendations on unregulated financial markets and products.
The IOSCO made these recommendations in response to the
G-20’s concerns regarding the role that certain unregulated
market segments and products, such as securitised products and
the CDS market, played in the crisis and in the evolution of
capital markets.
The BCBS recently enhanced the Basel II
capital framework; changes included increased capital, risk
management, and disclosure requirements for certain
securitisation activities.
Supervisors and market
participants have taken steps in response to some of the gaps
and risks identified in this report.
Notably,
supervisors have worked with market participants to promote
greater use of central counterparties (CCP) for clearing
standardised CDS contracts.
The use of a CCP, which
replaces bilateral counterparty relationships by acting as a
seller to every buyer and as a buyer to every seller, might
constitute the first step in a possible evolution toward greater
exchange trading, with attendant transparency benefits in
addition to clearinghouse settlement.
Instead of being
exposed to each other, the protection buyer and seller are
exposed to the CCP.
The CCP, in turn, manages
counterparty risk by imposing robust risk management and
margining requirements on its members.
While increased
use of CCPs can mitigate some of the risks associated with
complex webs of counterparty exposures, they may also result in
concentration of risk in CCPs, which therefore require robust
supervision.
As this report was being published, several
regulated CCPs had been established, or were in the process of
being established, in the United States and Europe.
Transparency has been enhanced in the CDS market, particularly
through the Depository Trust & Clearing Corporation’s Trade
Information Warehouse, which is a contract repository containing
electronic records of a large and growing share of CDS trades.
The repository greatly enhances data being collected by
the Bank for International Settlements and various industry
groups.
A number of steps have been taken to strengthen
the CDS market infrastructure.
For example, major dealer
firms have worked with supervisors and regulators to reduce
confirmation backlogs and to enhance electronic processing of
transactions.
In April 2009, the International Swaps and
Derivatives Association implemented changes to standard CDS
documentation that incorporated auction settlement terms to cash
settle CDS transactions as an alternative to requiring
physical delivery of securities (the so-called “Big Bang
Protocol”).
Auction settlement mitigates the risk of
large market movements based solely on the need for
counterparties to access securities when the volume of
outstanding CDS contracts exceeds the underlying value of debt.
III. Key issues and gaps common to both CDS and FG insurance
While CDS and FG insurance products can share a common
purpose and economic substance and are similarly complex, they
face differing regulatory oversight, market exposure, and
reserve requirements.
CDS are largely unregulated
financial instruments, although the use of such instruments is
subject to supervision and regulation in cases when buyers and
sellers of this protection are regulated institutions.
CDS products written or traded OTC by regulated firms may be
subject, to a varying extent across sectors and jurisdictions,
to regulatory capital requirements, restrictions, and, in some
cases, limits on use and disclosure/reporting requirements.
In addition, to the extent that unregulated entities (eg
special purpose entities or hedge funds) are major participants
in CDS markets, their lack of regulation may constitute a
significant regulatory gap.
For example, even if
regulated firms are subject to capital requirements for their
exposure to risks arising from their CDS exposures, if
unregulated firms that are systemically important are not
subject to comparable requirements, this may pose a systemic
risk.
CDS are traded instruments, whereas FG insurance is
a non-traded insurance product.
Because buyers of
protection using CDS do not need to have an insurable interest
in the underlying reference entity (ie they do not need to own
the security for which they are purchasing protection,)
protection can be purchased for either hedging or trading
purposes.
Buyers also may purchase multiple contracts
written against the same credit event, so the notional amount of
CDS protection written against a reference entity may far exceed
the outstanding amount of underlying debt, a situation that
could have widespread implications for risk management.
FG insurance, in contrast, is not traded OTC or on any market,
and FG insurers, which are largely regulated entities, are
required to maintain capital reserves. As a result, generally
they cannot write protection in amounts that exceed the
underlying debt that they ar insuring.
The insurable
interest requirement ensures that the actual amount of credit
risk transferred in the market cannot exceed the notional amount
of credit risk actually existent in the financial market.
This inability to leverage limits the systemic impact of
these FG contracts.
While established as regulated
insurance entities, the business model required ring fencing
this type of product from more general forms of insurance and
did not include access to any type of guaranty mechanism. These
products were viewed as risk transfer from one financially
sophisticated party to another.
Finally, concentration
risk is a systemic concern both in the CDS market and among FG
insurers that gives rise to supervisory concerns.
A. Inadequate risk governance
Sellers of credit protection did not, and often could not
(given their existing risk management infrastructure) adequately
measure the potential losses on their credit risk transfer
activities.
This was generally true in the CDS market and
to a lesser extent in the regulated FG insurance market, where a
minimum statutory financial reporting exists.
Buyers of
protection did not properly assess the ability of sellers to
perform under the contracts; they permitted imprudent
concentrations of credit exposures to uncollateralised
counterparties.
B. Inadequate risk management practices
The inadequate management of risks associated with CDS
transactions have, in at least some instances, contributed to
financial instability and harmed market confidence.
While CDS per se have not been primary contributors to the
crisis, poor risk management by some institutions that were
important participants in CDS markets did exacerbate systemic
risk.
In at least one high-profile case, a firm sold
protection to other large financial firms on a massive scale
(some observers have characterised this as writing deep
out-of-the-money options on the state of the economy).
But the firm, assuming that the aggregate risk arising from
these transactions was de minimis, failed to hold sufficient
capital or to ensure that it had ready access to sufficient
liquid financial resources to meet possible credit
downgraderelated margin calls.
The firm’s
counterparties, in turn, did not impose sufficiently rigorous
initial or variation margin requirements on the protection
seller.
Indeed, subsequent credit downgrades of both the
firm and the subprime-related securities on which it had written
protection resulted in collateral calls that the firm could not
meet.
Concerns about knock-on effects throughout the
financial system resulted in large-scale, and unprecedented,
government support.
In this instance, inadequate risk
management by the protection seller and its counterparties
resulted in a buildup of systemic risk that went largely
undetected by supervisors.
The concentration of CDS
contracts in a small number of market participants (eg
significant CDS dealers or sellers of protection ) could be
problematic for their counterparties if they were unable to
perform.
This has raised the specter that some firms,
while not necessarily viewed as too big to fail purely on the
basis of size, may nevertheless be considered too interconnected
to fail because of the impact that their failure could pose -
with the CDS market as one of a variety of transmission
mechanisms - to the broader financial system.
The crisis
exposed a lack of effective risk management by a number of FG
insurers.
Their expansion from underwriting of municipal
issuers to higher-risk lines of business, such as the
underwriting of asset-backed issues, together with expanded
geographical reach was not
accompanied by an appropriate
increase in risk governance and risk management awareness or an
updating of risk management controls to monitor exposures and to
assess capital requirements.
More sophisticated analysis
of the different financial and other sectors, together with an
understanding of the combined effect of deteriorating market
conditions and increased risk correlation within the global
financial markets, may have identified potential problems at an
earlier stage and gone some way toward mitigating the severity
of losses.
The Financial Accounting Standards Board
(FASB) in its statement number 163 now requires additional
disclosure of risk management activities by FG insurers.
Those activities include ones adopted by FG insurers to
evaluate credit deterioration in insured obligations.
Some firms built up overall levels of risk that should have been
subject to limits even if the probability of having to pay out
was considered very low. While the perceived risk of selling
protection against highly rated exposures was very small, it was
not risk-free.
A fundamental risk management tenet is
that firms should limit the risks of such low-probability,
high-impact, positions.
Writing deep out-of-the-money
options can pose catastrophic risk, so proper risk management
and governance practices should have prevented the buildup of
such large exposures.
Further, adequate stress testing
should have made potential problems apparent as the crisis
began.
The failure to effectively manage counterparty
credit risk in the CDS market can have a potentially systemic
impact.
In particular, if a large protection seller were
unable to meet its obligations to counterparties (including
payment in response to a credit event or posting of collateral
in response to credit downgrades), this could have adverse
consequences for market liquidity, which could create liquidity
and solvency problems for market participants well beyond the
parties to the CDS contract.
Correlation between the
creditworthiness of a protection seller and the reference entity
could increase the risk that the protection seller’s ability to
meet its obligations might decline at the same time that a
credit event is most likely.
Firms that are significant
CDS market participants also may be exposed to potentially
substantial operational risk.
This can, among other
things, take the form of legal documentation risk (ie are
contractual terms clear and unambiguous, for example, with
regard to the definition of a credit event?) and settlement risk
(ie can firms deliver securities or cash as required by the swap
contract following a credit event?).
Market participants
must have appropriate back-office personnel and infrastructures,
including information technology and management reporting
systems commensurate with the nature and level of market
activity. Operational risk at the firm level is closely related
to broader market infrastructure issues.
Inadequate risk
management within FG insurers raises fundamental issues. When
the credit worthiness deteriorated market perceptions resulted
in the “good” risks becoming tainted by the “bad.”
Risk
concentrations were not adequately monitored or properly
understood.
Hence, while downgrades from the credit
rating agencies led to calls for collateral to be posted in the
case of some FG insurers, the downgrades also led to increased
claims at the same time FG insurers were experiencing
mark-to-market losses.
Liquidity risk management
processes also did not factor in the risks of the lack of
availability of contingent capital, an increase in the cost of
capital, or the potential for increased collateral requirements.
Uncertainties about counterparty credit risk within
financial markets means that FG insurers have been unable to
sufficiently identify risks, especially remote exposures.
In addition, assessments undertaken by insurers on their
exposure to any one counterparty, or to particular risk factors
(eg exposure to real-estate markets arising from insurance of
complex
structured instruments) were inadequate.
If
all of the relevant information is not available for analysis,
the correlation of risks underwritten by FG insurers cannot be
assessed.
Altogether, there has been a lack of adequate
corporate governance and internal controls at FG insurers,
including management oversight and understanding of the risks
being underwritten.
C. Insufficient use of collateral
While most major firms active in the OTC derivatives market
collateralise their exposures on a daily basis, market
convention permitted firms with the highest credit ratings not
to provide collateral to secure their derivatives obligations.
They have infinite thresholds (ie there is no payable
amount that would call for a collateral posting requirement to
the dealer).
Contractual requirements may call for
these highly rated firms to post collateral once the firm’s
rating falls to a specified credit level.
The absence of
collateral posting requirements often has led such firms, some
of which were systemically important, to amass a portfolio of
OTC derivatives far larger, and with more risk, than would have
been the case if they were subject to normal market standards.
The contingent liquidity risk that these firms assumed,
in the event of a credit downgrade, was excessive. Contractual
arrangements permitting infinite thresholds for systemically
important market participants invites the systemic liquidity and
credit problems that occurred during the crisis.
D. Lack of transparency
These concerns have been exacerbated by the opacity and
complexity of CDS instruments and by a lack of transparency in
the market (because CDS are OTC instruments) that made it
difficult for either supervisory authorities or market
participants to understand where, and to what extent, credit
risk had been assumed or transferred.
It was widely
assumed that the CDS market had resulted in diversification of
credit exposure across the financial system.
While this
was true to a large extent, some firms nevertheless built up
concentrations that were not detected ex ante. This lack of
transparency, in turn, has been heightened by the increased
participation of unregulated entities (such as hedge funds) -
which can be opaque to market participants and supervisors - in
the CDS market as protection buyers and sellers.
Supervisors have expressed concerns that opacity in the CDS
market may result in market misconduct (ie manipulation or
insider trading), while a lack of transparency may have made it
exceptionally difficult for market regulators to detect such
misconduct.
This is a particular concern because of the
large impact that news about a company (especially regarding its
creditworthiness) may have on CDS spreads of the underlying
company.
In addition, CDS spreads can have an effect on
price movements in bond and equity markets, which supervisors
and regulators have varying degrees of ability to oversee.
Moreover, the lack of transparency in the CDS market with
respect to prices, trading volumes, and aggregate open interest
makes it difficult for market participants to assess conditions
in the credit cash and equity markets.
The potential
impact of CDS spreads on related markets has grown as the volume
of outstanding CDS has in many cases far outstripped the value
of the underlying reference debt.
There was, to a lesser
degree, a lack of transparency in relation to some exposures as
the risks underwritten by FG insurers became further removed
from the original underlying issuer risk.
There may have
been several tranches of securitisation between the debt
security insured by FG insurers and the original mortgage or
other debt.
This complexity - which resulted in a lack
of transparency - made it difficult for FG insurers to monitor
risk exposures, especially correlation risks, accurately and to
estimate losses.
While the municipal risk exposures may
have remained relatively less complex, and therefore easier to
assess, other exposures, such as pooled corporate exposures and
pooled consumer-related risks (eg mortgage securities), became
increasingly difficult to assess.
A lack of transparency
in the CDS market may have exacerbated problems during periods
of significant stress.
This lack of transparency can be
attributed not only to potentially insufficient disclosures by
individual institutions but also to the OTC nature of CDS
contracts that prevents aggregation of data across firms. This
poses several related risks.
First, from a
macroprudential perspective, it has been difficult for
supervisors to understand the extent to which credit risk has
either been transferred or concentrated across the financial
system.
Second, limited disclosure requirements make it
difficult for market participants to identify firms with
significant concentrations of CDS exposures, especially at major
dealers and protection sellers.
This can impact not only
significant market participants, but also the market more
broadly to the extent that market participants pull back in the
face of uncertaint about risk concentrations.
Finally,
asymmetric information (when one party involved in a transaction
has more information than the other) and/or market opacity may
mask potential market integrity problems.
Market
integrity issues can be caused by involvement in multi-tranched
obligations in which the risks are inherently more difficult to
evaluate, where the exposures are more difficult to quantify,
and where market participants do not or cannot assess the risks
arising from their exposure to FG insurers.
There are
typically a large number of counterparties in each transaction,
each earning fees and premiums.
This means that the
process is subject to tension whereby one party has more
information than another about a portfolio of risks.
The
seller at each stage may pass progressively less information to
the buyer and therefore the knowledge of the original risk
becomes diluted at each stage.
E. Vulnerable market infrastructure
The limited pool of FG insurers and FG reinsurers and CDS
dealer firms means that risk is concentrated in a relatively
small number of firms.
Some FG insurers are moving
toward runoff or seeking to commute their liabilities (ie
disposing of their liabilities in a manner that provides
certainty) to reduce the potential adverse impact on their
capital.
Unless new capital enters the market and doubts
about the continued viability of the FG insurance business model
can be addressed, the pool of FG insurers could be further
reduced.
While concentration risk is a systemic concern
both in the CDS market and among financial guarantee insurers,
the interconnectedness of CDS market participants (especially
the major dealer firms) gives rise to unique supervisory
concerns.
Basel Committee on
Banking Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Conglomerates
- Part 1:
Introduction, Mandate, Focus and guiding principles of this study,
Key issues and gaps
Conglomerates - Part 2:
Supervision and regulation of financial groups. Mortgage
origination. Hedge funds
Conglomerates - Part 3:
Recommendations and options for effective and consistent
financial regulation across sectors. Reducing key regulatory
differences across the banking, securities, and insurance sectors.
Strengthening supervision and regulation of financial groups.
Promoting consistent and effective underwriting standards for
mortgage origination. Broadening the scope of regulation to hedge
fund activities
Conglomerates - Part 4:
Strengthening regulatory oversight of credit risk transfer
products. Key differences in regulation across the banking,
securities, and insurance sectors.
Background and approach adopted by the Joint Forum. Key issues
and gaps
Conglomerates - Part 5:
Recommendations to reduce key differences in regulation across
the banking, securities, and insurance sectors. Supervision and
Regulation of Financial Groups. SPEs. Key issues and gaps.
Recommendations to strengthen supervision and regulation of
financial groups
Conglomerates - Part 6:
Mortgage Origination. United Kingdom, United States, Spain,
Canada, Germany. Key issues and gaps. Recommendations to promote
consistent and effective underwriting standards for mortgage
origination
Conglomerates - Part 7:
Hedge Funds. Key issues and gaps
Conglomerates - Part 8:
Recommendations and policy options to broaden the scope
of regulation to hedge fund activities.
Credit Risk Transfer Products.
Key issues and gaps common to both CDS and FG insurance (CDS -
Credit default swaps, FG - Financial guarantee)
Conglomerates - Part 9:
Key issues and gaps specific either to CDS or FG insurance.
Recommendations and policy options to strengthen regulatory
oversight of credit risk transfer products
Conglomerates - Part 10:
Annex 1-9
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