02 April 2008

BCBS: Joint Forum consults on Credit Risk Transfer

The Joint Forum released for consultation on Credit Risk Transfer responding to the request from the FSF. The paper is focused on the performance in the last two years of credit default swaps and collateralized debt obligations. The paper makes a number of recommendations that the industry and regulatory community can take to enhance the robustness of their risk management and oversight of these products (Section 10).

The report describes the growth in CRT since the last Joint Forum report in 2005 and addresses question of who bears the credit risk that is transferred via CRT.

The report identifies how CRT contributed to the recent market turmoil and answers the to the four questions about CRT posed by the FSF.

Finally, the report documents the concerns that supervisors have about CRT (in section 9) and makes recommendations for market participants and supervisors (in section 10).

Main findings of the paper include:

Some investors may not have fully appreciated the higher-risk nature of the new products.

The originate-to-distribute model created incentives that resulted, in some cases, in weak origination standards for products such as subprime mortgages.

Some investors placed excessive reliance on credit rating agency ratings. Firms also appear to have had few, if any, risk management processes in place to address risk exposures associated with off-balance sheet entities such as SIVs.

The structured credit market is likely to survive, but will remain weak for a period of time.

Supervisors remain concerned about several aspects of the CRT market: its complexity; valuation issues; liquidity, operational and reputational risks; and the broader effects of the growth of CRT.

Supervisors believe that market participants must better understand the structure and risks of the CRT products in which they invest, as well as how the rating agencies assign ratings to specific instruments and what circumstances would lead them to downgrade ratings.

With continued innovation in the CRT markets, the effort and resources that firms and regulators will need to expend to properly understand these instruments increases significantly.

Any future “misunderstandings” of risks involving CRT instruments will probably involve a new and different flavour of products and may be no more likely to be detected in advance, with the current level of supervisory resources.

Deadline for comments is 16 May 2008.

Press release

Consultation paper

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