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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)
IV. Key issues and gaps specific either to CDS or FG insurance
In addition to the common issues and gaps discussed, there
are important issues of concern that are specific to each of
these credit risk transfer products.
A. Key issues and gaps specific to CDS
The use of CDS contributed positively and negatively to the
financial crisis.
On the one hand, firms used CDS
products to more actively manage credit risk, and CDS spreads
are increasingly used by market participants (and, in some
instances, by supervisors as a supplemental indicator of market
sentiment) as a tool for assessing a reference entity’s
creditworthiness.
Despite supervisory and industry
concerns about the CDS market infrastructure having been raised
in previous Joint Forum reports on credit risk transfer and by a
number of supervisory authorities, the market has been fairly
resilient to date.
This is evidenced by several large,
high-profile credit events (eg the September 2008 bankruptcy of
Lehman Brothers and the placement into conservatorship of the
Federal National Mortgage Association and the Federal Home Loan
Mortgage Corporation in the United States).
In addition
to the gaps and issues discussed above in section III,
a number
of supervisors (domestically and through international fora such
as the Joint Forum) raised concerns about potential weaknesses
in the market infrastructure for CDS prior to the financial
crisis, particularly since CDS are typically traded OTC.
Steps taken by supervisors and market participants (eg
credit event auctions) in response to these concerns likely
contributed to the effective functioning of the market
infrastructure throughout the crisis.
Nevertheless,
further strengthening of the market infrastructure to mitigate
systemic risks remains a high priority.
Operational
risks remain an issue at specific firms, and these operational
risks can be exacerbated by weaknesses in market infrastructure.
Moreover, effective management of settlement risk,
especially where firms have large counterparty exposures, is
essential at both the firm and market level.
In
addition, effective collateral management is an essential
element of risk management.
This can be complicated by
the cross-border nature of many CDS transactions, which can pose
additional settlement and, potentially, legal risks.
Steps taken to date to address issues and gaps related to market
infrastructure and operational risk are discussed in the
background section of this chapter.
B. Key issues and gaps specific to FG insurance
The number of financial guarantee insurers worldwide is
small. There are fewer than 10 in the United States alone, but
they operate across international boundaries.
They have
offices - with varying volumes of business - in
Australia, Bermuda, France, Italy, Japan, Spain, and the United
Kingdom.
Consequently, this may give rise to systemic
risks across borders.
The regulation of these insurers
varies considerably across jurisdictions.
Some have
specific legislation for financial guarantee insurance (eg
segregating such provision of insurance into separate firms) and
others regulate financial guarantee insurance in the same way as
traditional general insurance business.
Historically,
default rates on the underlying municipal bonds covered by FG
insurance have been very low.
In more recent years, FG
insurers have expanded into the provision of insurance on
asset-backed securities, such as CDOs.
As the FG
insurers expanded their business lines, they changed their risk
appetites and insured more complex structured securities, such
as subprime mortgage backed securities (including the most
senior AAArated tranches and higher-risk mezzanine tranches)
without a commensurate adjustment of their risk management
frameworks.
Following concerns about
excessive defaults
in the subprime markets, credit rating agencies required FG
insurers to increase their capital levels or face downgrades
(most of the FG insurance industry was, in fact, downgraded
during the recent crisis).
The downgrade of an FG
insurer could have an impact on the value of the underlying bond
or other asset that it has insured.
FG insurers have also
established minimally capitalised SPEs, which sold CDS that were
not legally permitted within the main FG insurance business.
The FG insurers would then guarantee the obligations of
these SPEs, notwithstanding that the credit events they were
covering went beyond the scope of risks that they could have
written within the regulated FG insurance business.
The
FG insurance business model was developed in the United States.
Historically, the AAA ratings of FG insurers provided
credit enhancement to bond issuers by providing a guarantee of
payment of principal and interest to the bondholder in the event
of an issuer default.
The business originated in the
early 1970s to provide guarantees in respect of municipal bonds.
The AAA rated guarantee, in the form of an insurance
contract, enabled municipal issuers to reduce their total cost
of debt.
The rating agencies would confer the rating of
the FG insurer on the debt issue and, therefore, the bonds could
be sold at lower rates of interest than would otherwise be the
case.
Vitally, FG insurance and the benefit of the AAA
rating it conferred was more cost effective to issuers than the
expense that would have been incurred had the issuers attempted
to obtain a AAA rating in their own right.
In order to
maintain their essential AAA rating from the credit rating
agencies, the FG insurers maintained a “zero-loss” or
“remote-loss” underwriting approach, writing primarily municipal
and state governmentissued securities.
The insurance
guarantee covered only those with an insurable interest in the
debt.
It would only be triggered in the event of an
actual default and not merely a downgrading of the issuer’s
credit rating. The FG insurer must honour the original interest
and principal repayment terms but is not obliged to repay the
principal immediately on a default event.
The
FG
insurance therefore does not have immediate cash flow issues
when a claim arises.
Insurance legislation in the United
States prevented general property and casualty insurers from
writing this business and effectively ring fenced the FG
insurance business into a few so called “monoline” insurers. FG
insurers also operate from other jurisdictions, sometimes but by
no means always, as monoline insurers.
Some, but not all,
FG insurers are active in the FG insurance reinsurance market.
The principles on FG insurers covered by this chapter
apply equally to the FG insurance reinsurance market.
The
problems outlined below have been widely attributed to
“monolines,” which as noted above is a term that is commonly
applied to FG insurers.
However, the term “monoline” is
misleading as entities known as monolines engage in a range of
specialised lines of business in different parts of the world.
In addition, some jurisdictions have segregated the FG
insurance business as separate entities and others have not.
Therefore, the effect on bond and other markets of any
credit rating downgrades to FG insurers has been more pronounced
in some jurisdictions than in others.
A lack of
consensus on the legislative treatment and differing regulatory
treatment of FG insurance business across jurisdictions
contributed to the lack of transparency in the markets.
The financial crisis generated problems for FG insurers in both
the traditional markets involving bond insurance and in the
business written by their SPEs.
These problems were due
to a number of factors, which are outlined below.
The FG
insurance market is still under significant stress, as reflected
in the downgrading, placement on negative outlook, or withdrawal
of ratings of some FG insurers by the rating agencies.
Although the amounts paid out by FG insurers have been
considerably less than was first estimated, and some have been
able to raise additional capital, others have gone into run-off
or retreated back to underwriting only municipal bond business.
As the crisis has demonstrated, there are potential
risks and issues which could have a cross-sectoral and/or
systemic impact.
Accounting
practices.
Divergent and inadequate reserving
practices resulted in inconsistencies in the recognition and
measurement of claims liabilities.
Reserving was also
generally based on a cash, rather than on an accrual basis,
meaning that claims were underestimated and that rating agencies
relied in part on assessments of these reserves in assigning
credit ratings to FG insurers.
In recognition of the
diversity that existed in accounting for FG insurance contracts
by insurance enterprises, the FASB issued Statement of Financial
Accounting Standards No. 163, which is effective for accounting
periods beginning on or after 15 December 2008.
The
statement requires that claim liabilities be recognised prior to
an event of default where there is evidence of credit
deterioration in an insured financial obligation.
The
statement also clarifies the recognition and measurement of
premium revenue, where inconsistencies also existed, by linking
the recognition of revenue to the amount of insurance protection
and the period in which it is provided.
The expanded
disclosures required by the FASB regarding FG insurance
contracts should improve the quality and comparability of
financial reporting by FG insurers.
Irrespective of
accounting requirements, firms had an obligation to understand
the risks that they were amassing, even if there were no current
demands for collateral.
Firms that took a mark-to-market
perspective for risk management purposes, even if they reported
on a cash basis, would have seen red flags about potential
credit downgrades and calls on liquidity.
Capital and liquidity.
Some
FG insurers held capital that was inadequate and not
commensurate with their risk profiles. Historically low loss
ratios led the FG insurers to act as though they were writing
“zero loss” or “remote loss” insurance (ie as though claims
would very rarely crystallise).
There was
a lack of
appreciation of the need to maintain capital and liquidity at
sufficient levels to survive the adverse events which developed.
In practice, capital levels were largely driven by the
requirements of the rating agencies in relation to maintaining
AAA status rather than by a firm’s own analysis of its capital
requirements.
It was apparent that, once in difficulty,
the FG insurance sector did not have sufficient financial
flexibility to access additional liquidity or capital at
reasonable cost.
Historically, the levels of losses were
such that the FG insurance sector had ample time in which to
plan its capital management.
In this instance, however,
FG insurers were unable to respond to the rapid development of
the crisis and many were left with capital shortfalls.
The market also needs to address the management of collateral;
some FG insurers were not able to deal with the requirement for
increased collateral to be posted when they were downgraded by
the rating agencies.
While an FG insurer may have
sufficient liquidity to make required payments on defaulting
guarantees as they become due, some FG insurance contracts
allowed other counterparties the right to
demand collateral
following the downgrading of an FG insurer.
In such
circumstances, counterparties can require collateral to back up
the insurance guarantee even on securities which have not
defaulted. Much depends on the terms of the original guarantees
that were issued, as some FG insurance contracts did not require
any collateral to be posted.
Role
of credit rating agencies.
There appears to have
been an overreliance on rating agencies to determine the rating
of the securities being underwritten rather than FG insurers
undertaking their own evaluation of the underlying risks.
As part of the underwriting process, the sector apparently
did not undertake sufficient in-depth analysis of the underlying
risks (including, for example, deteriorating underwriting
standards in mortgage markets) of the securities they were
insuring.
The simple monitoring of movements in credit
ratings was not a substitute for the ongoing monitoring of the
risk following the original underwriting decision.
The
rating agencies rated the FG insurers as well as the underlying
exposures; therefore, the entire market was based essentially on
the views of the rating agencies.
The downgrading of
credit ratings had a fundamental effect on the FG insurance
market.
The impact of a downgrade in the rating of an FG
insurer was to trigger contractual conditions requiring the
posting of collateral or, in some circumstances, the unwinding
of contracts.
The role of the credit rating agencies in
the financial crisis has been well documented elsewhere.
Many of the now-problematic transactions, such as highrisk
mortgage-backed securities, were rated AAA by the rating
agencies at the time those securities were issued. Other
counterparties may have difficulty in evaluating rating agency
conclusions because each agency has its own criteria and
methodology which are not always transparent to the market.
Since the credit rating is a key parameter in the business
plans of the FG insurers, and in those of their counterparties,
it is important that there is consistency and transparency in
the rating
process.
Any downgrade in a rating not
only affects the business outlook of the FG insurers but also
feeds through to the rating of those securities for which
insurance guarantees have been issued.
Use of special purpose entities.
The establishment and use by FG insurers of unregulated
SPEs, which had no capital or reserve requirements and which
were reliant on support from the FG insurers, exacerbated the
problems of the insurers.
All of the issues described
above were therefore magnified in these SPEs, but this became
apparent only when the crisis was well underway.
The
wider risk issues posed by SPEs - to which the FG insurance
sector is not immune - are described in the 2009 Joint Forum
Report on Special Purpose Entities.
All of the above
factors resulted in FG insurers becoming highly leveraged when
measured by total insured exposures relative to claims paying
resources.
An FG insurer’s value is extremely sensitive
to downgrades in the credit rating of its financial strength, so
that any decline has a significant impact on its future business
prospects.
High operating leverage increases the
potential for such rating downgrades, particularly when there
are large, correlated risk exposures which will have a negative
impact if the performance of those exposures deteriorates.
Knock-on effects.
There
are further risks which are related to market infrastructure,
including poor segregation of the risks associated with
different lines of business so that adverse impacts on capital
and solvency from the higher-risk business have an impact on the
traditional municipal bond insurance business.
The
higher-risk business has been characterised not just by higher
premiums but also by greater default intensities and size of
losses.
The capital bases of the FG insurers may not be
sufficiently strong to withstand the increasing demands of these
higher-risk areas of structured finance.
V. Recommendations and policy options to strengthen regulatory
oversight of credit risk transfer products
In light of the role that inadequate management of risks
associated with credit risk transfer products played in the
crisis, supervisors should consider various actions - on either
a national or international basis - to address these risks.
This report focuses on two prominent products for
transferring credit risk: credit default swaps (CDS) and
financial guarantee (FG) insurance.
While
CDS and FG
insurance share some similar characteristics (notably, they both
transfer credit risk but give rise to counterparty credit risk,
operational risk, and risks related to a lack of
transparency, among others), there are significant differences
between the two that merit unique consideration.
As the
guiding principles presented elsewhere in this report suggest,
the supervisory and regulatory requirements applied to
activities that appear to have similar economic substance (eg
transfer of credit risk via CDS and FG insurance) should
adequately reflect any similarities and differences.
Consequently, some recommendations for addressing gaps in
oversight apply to both CDS and FG insurance, while others are
more narrowly focused on one or the other.
Many of the
recommendations and options presented below have been discussed
in other international fora or in jurisdictions.
They
are reiterated in this report because the Joint Forum seeks to
provide a broad range of recommendations and options for
addressing gaps in oversight.
Moreover, the Joint Forum
welcomes efforts that have been undertaken since the onset of
the crisis and supports further international work to address
these gaps in an appropriate manner.
Some of the
recommendations and options below reiterate, for example, the
detailed recommendations in IOSCO’s September 2009 report on
Unregulated Financial Markets and Products in the areas of risk
management, transparency, and market infrastructure.
In
the context of promoting more stable and transparent markets,
reducing systemic risk, and restoring confidence, several
central counterparties (CCP) for trading over-the-counter
derivatives - such as CDS - have been established and have begun
operation; capital requirements for the use of such instruments
have been increased for banking organisations; transparency has
been enhanced; and steps have been taken to reduce operational
and settlement risks.
Recommendation n° 13:
Supervisors should encourage or require greater transparency for
both CDS and FG insurance.
Supervisors
should continue to
support initiatives to store CDS trade data in repositories (eg
the Depository Trust & Clearing Corporation’s Trade Information
Warehouse).
Supervisors should encourage or require
firm-level public disclosures (to provide transparency for
investors) and/or enhanced regulatory reporting (to provide
transparency for supervisors).
Such disclosures could
include, for example, risk characteristics of instruments, risk
exposures of market participants, valuation methods and
outcomes, and, off-balance sheet exposures including investments
with unregulated entities and contractual triggers that may lead
to the posting of collateral, claims payment, or contract
dissolution.
Supervisors should promote, in the context
of wider liquidity considerations, the appropriate and timely
disclosure of CDS data relating to price, volume, and open
interest by market participants, electronic trading platforms,
exchanges, data providers, and data warehouses.
With this
greater transparency, supervisors should, to the extent
feasible, monitor concentrations that could pose systemic risks.
Such disclosure should be calibrated to avoid
detrimental impact on market liquidity.
Supervisors
should develop tools to conduct enhanced surveillance of CDS
markets to detect and deter market misconduct.
Recommendation n° 14:
Supervisors should continue to work together closely to foster
information-sharing and regulatory cooperation, across sectors
and jurisdictions, regarding CDS market information and
regulatory issues.
Supervisors should cooperate and
exchange information on the potential cross-sectoral and
systemic risks raised by stress and scenario testing of FG
insurers.
Recommendation n° 15:
Supervisors should continue to review prudential requirements
for CDS and FG insurance and take action where needed.
This includes:
Setting appropriate regulatory capital
requirements for CDS transactions.
Establishing minimum
capital, solvency, reserving, and liquidity requirements for FG
insurers (including requirements for the use and actuarial
approval of internal models) with appropriate levels of surplus
to policyholders factored into these requirements.
Monitoring the exposure and concentration of risk by FG insurers
with reinsurers.
Requiring firms to undertake aggregated
risk analysis and risk management, including counterparty risk
arising from exposures via CDS or FG insurance, as well as the
potential effect of special-purpose entities and other external
vehicles that could affect a FG insurer, so the insurer is not
compromised by the failure of such vehicles.
Applying
robust counterparty risk management arrangements, including
requirements for all important counterparties to post collateral
to secure their obligations.
Ensuring that the corporate
governance process of an FG insurer is commensurate with its
risks.
Recommendation n° 16:
Supervisors should continue to promote current international and
domestic efforts90 to strengthen market infrastructure, such as
supervised/regulated CCPs and/or exchanges.
This should
include encouraging greater standardisation of CDS contracts to
facilitate more organised trading and CCP clearing, more
clearing through central counterparties for clearing eligible
contracts, and possibly an evolution to more exchange trading.
There should also be enhanced dialogue among supervisors
of CCPs regarding applicable standards and oversight mechanisms
for CCPs.
Recommendation n° 17:
Policymakers should clarify the position of FG insurance in
insurance regulation, if this is not already the case, so it is
clear that the provision of FG insurance is captured by
regulation and is subject to supervision.
Options to be
considered
Among the more specific options that
supervisors are exploring or that may be explored in the future,
are:
• Ring-fencing and protecting from the potential
losses of other business lines the traditional business
underwritten by FG insurers (eg wrapping municipal bonds) so it
is separately reserved and capitalised.
• Prohibiting or
limiting exposure by FG insurers to pools of asset-backed
securities that are partly or wholly composed of other pools.
• Requiring FG insurers to set maximum limits for exposure
to any one risk or group of risks, such as a particular
counterparty or category of obligation, by reference either to
the aggregate exposure or to capital levels;
• Limiting
the notional value of aggregate exposures, either by
counterparty or by risk factor, in relation to levels of capital
or by other appropriate measure.
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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