Technische Universität München Credit as an Asset Class - risklab

CHAPTER 2. CREDIT RISK TRANSFER
• Systematic mispricing – Models for pricing credit derivatives are in an early de-
velopment stage. There is no generally accepted pricing model. Partly, the used
models are insufficiently able to map complex portfolio products, which can lead to
an underestimation of the real risk, and thus to undesirably high risk and to a wrong
allocation of resources with a disequilibrating impact on financial stability.
• Agency risk – In terms of occurrence probability and expected amount of loss, protec-
tion sellers are able to better evaluate the transferred credit risk than the protection
buyers. Therefore, there is a danger that the protection sellers only sell bad risks.
This phenomenon is also known as adverse selection. A further agency problem may
accrue from the fact that, after the credit risk transfer, the protection buyer has
little incentive to monitor the borrower in order to influence the occurrence proba-
bility and expected amount of loss in case of default. At the granting of a credit, a
bank might be even less careful, knowing that she will hedge the credit risk. This
phenomenon is known as moral hazard. 30
• Regulatory arbitrage – Banks effectively hedge against certain positions in their port-
folio by transferring the inherent credit risk to counterparties. This is particularly
done with positions requiring more regulatory than economic capital. Thus, regula-
tory capital relief is accomplished, while credit risk exposure may then be assumed
by less regulated market participants. This could result in an inefficient risk al-
location as risk is systematically taken over by market participants that have less
knowledge and experience in dealing with risks. Furthermore, they might have a
smaller capital cushion to absorb unexpected losses as they are not regulated. Reg-
ulatory arbitrage exploits inconsistencies in capital regulation and is one of the main
reasons for continually improving capital requirements. 31 32
• Market intransparency – As the credit derivatives market is an over-the-counter
(OTC) market, there is an information deficiency. Information regarding the trading
volume of credit derivatives often has been based on estimations and polls among
market participants, but not on disclosure requirements. This insufficient trans-
parency in the market and the lack of insight into firm level exposures and positions
has prevented an adequate assessment of the risk allocation within a national econ-
omy. Hence, the possibility to early identify potential systemic risks threatening the
stability of the financial system is limited. There are efforts to improve the trans-
parency and disclosure requirements with respect to financial institutions. Not all
market participants, however, can be included. 33
To conclude, there are several risks in credit derivative markets that can potentially
threaten the stability of financial markets. They are particularly important until the
market is mature. At this stage, some risks have already been reduced successfully, for
30
This risk is more likely to be of theoretical nature. In practice, there are several mechanisms that
prevent these risks such as reputation effects and retention. (See [DBR04], p. 13, [Deu04], p. 42.)
31
Regulatory arbitrage is to be prevented through the implementation of Basel II as regulatory capital
is calculated by taking into account the borrower’s and the counterparty’s credit quality.
32
Deutsche Bundesbank considers risk for the stability of financial markets accruing from regulatory
arbitrage not to be pivotal. (See [Deu04], p. 41.)
33
See [Deu04], p. 37-45, [DBR04], pp. 1-14, [BOW03], p. 211, [Fit05], pp. 2-3.
17