Tuesday, November 23, 2010

What Reforms for the Credit Rating Industry? A European Perspective (SSRN)

By Karel Lannoo (Centre for European Policy Studies, Brussels)

Abstract: Despite having singled out credit rating agencies (CRAs) early on in the financial crisis as needing more regulation, policy-makers in the EU seem not to be reassured by the measures that have been adopted in the meantime, and want to go further. This paper starts with an overview of the credit rating industry today. The second section analyses the use of credit ratings and shows how the authorities have created a captive or artificial market for CRAs. Section 3 reviews the new EU CRA regulation and its possible impact, and the final section compares proposals for regulatory reform.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1706623

Monday, November 22, 2010

The Effect of Market Structure on Counterparty Risk (SSRN)

By Dale W. R. Rosenthal

Abstract: Two network structures of derivative contracts are studied as representatives of a bilaterally-cleared OTC market and a centrally-cleared market. An initial bankruptcy induces counterparties to trade with price impact. The two market structures yield economically different price impact, volatility and follow-on bankruptcies. A large market-induced bankruptcy yields two destabilizing phenomena in bilateral markets: checkmate and hunting. Checkmate occurs when a counterparty cannot expect to prevent impending bankruptcy. Hunting occurs when counterparties push markets further than necessary, inducing further bankruptcies which may yield profits. The results suggest that bilateral OTC markets have larger externalities (distress volatility) which can be priced relative to centrally-cleared markets. Bilateral OTC markets are also more sub ject to liquidity and funding crises. This has real effects: follow-on bankruptcies, unemployment, a reduction in tax revenue, higher transactions costs, less risk sharing, and thus a reduction in allocative efficiency. Pricing the distress volatility may suggest when and how to encourage markets to transition from bilateral OTC to central clearing. The results also suggest that limiting leverage ratios may reduce distress, that leverage limits may not vary linearly with capital, and that in times of distress coordination by market authorities has value.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1571552

Friday, November 19, 2010

Australian and Japanese Authorities Seek Permanent SEC Rule 17g-5 Exemption

The Australian Securitisation Forum ("AuSF") and Japanese Financial Services Agency (FSA) have submitted letters to the SEC staff in which they have requested that the Commission make permanent the exemption for extraterritorial ratings from requirements of Rule 17g-5. Please click here for the AuSF letter and here for the FSA counterpart.

Wednesday, November 17, 2010

Only 11% of CDS positions were vis-à-vis a CCP (BIS)

The latest BIS seminannual OTC derivative survey introduced additional information on the importance of central counterparties (CCPs) in the CDS market:

At end-June 2010, about 11% of CDS positions were vis-à-vis a CCP. This relatively low share reflects the large amount of non-standard CDS contracts covered in the BIS survey, which are not easily traded with CCPs. In terms of market value, contracts with CCPs account for only 4% of the total value of CDS. The discrepancy between their shares of notional amounts and market values could reflect the fact that CDS indices, which are popular products cleared by CCPs, are often less volatile than other CDS, such as single-name CDS, because of the diversification benefits of the former. Approximately twice as many multi-names as single-name contracts are traded with CCPs.

For the graphics and tables, get the report here: www.bis.org/publ/otc_hy1011.pdf

Wednesday, November 10, 2010

Market structure developments in the clearing industry (CPSS)

During the last decade, the central clearing industry has experienced a large number of changes, which have profoundly affected both its role in the broader financial infrastructure and its own market structure. In June 2009, the Committee on Payment and Settlement Systems (CPSS) therefore commissioned a working group to investigate the developments in the clearing industry's market structure, their drivers and the implications for financial stability. The Working Group was also asked to assess whether different market structures give rise to new risks that may affect the robustness of central counterparties (CCPs) and to outline some practical issues for central banks, regulators and overseers with an interest in the stability of CCPs.

This report first provides a broad overview of the clearing industry in CPSS countries, covering both traditional markets and OTC derivatives markets. In particular, it describes developments in market structure between 2000 and 2010. Second, the report assesses how far these developments have given rise to new risks. It further outlines practical issues that central banks, regulators and overseers may wish to consider, either as part of their oversight role or in the context of their broader financial stability remit. Furthermore, the report examines to what extent changes in market structure or ownership might affect the expansion of central clearing services. Finally, the effect of ownership on CCPs' incentives to manage their counterparty risk is considered.

The report shows that different types of market structure have developed over the last decade. However, there is no evidence that the industry is settling on one particular structure. Specific market structures may create specific risks and amplify interdependencies between systems and markets. These warrant careful consideration by both market participants and the authorities. However, there is no evidence to suggest that one market structure is superior to another, either in terms of CCP risk management or in terms of wider systemic risk. In fact, many risks occur in several types of structures.

Nevertheless, central banks, regulators and overseers may usefully pay attention to specific risks that are more likely to occur in some market structures than in others. These include incentives to weaken the robustness of CCP risk controls that may in turn reduce in the CCP's ability to manage a member default. Although some of the risks considered in the report have yet to materialise, CCPs and their regulators or overseers face significant future challenges, in particular as market structures in many countries continue to evolve. Hence, public authorities will need to continue applying rigorous and consistent oversight.

The clearing industry's structure also has a bearing on how far central clearing will be used in different market segments, and hence on the resilience of the financial system as a whole. In fact, the broader risk-mitigation benefits of central clearing may be diluted if changes in market structure affect access to CCPs, raise the cost of central clearing or hamper the process of creating new CCP services.

Download here: www.bis.org/publ/cpss92.htm

Friday, November 5, 2010

The European Commission consults on rating agency policy

As part of its further work in creating a sounder financial system, the Commission services have launched today a broad consultation on credit rating agencies (CRAs). Whilst credit rating agencies are important actors in the financial markets, recent developments during the euro debt crisis have shown that there may be a need to re-examine certain aspects of the current regulatory framework. There are growing concerns that financial institutions and institutional investors may be relying too much on external ratings and do not carry out sufficient internal credit risk assessments, which may lead to volatile markets and instability of the financial system. The purpose of this consultation is to open a wider debate and get input from all stakeholders in order to calibrate the scope and ambition of any possible future legislative initiative in the field of credit rating agencies. These issues are similar to those raised at a global level in the recent Financial Stability Report. The deadline for replies is 7 January 2011.

Internal Market and Services Commissioner Michel Barnier said: "We need to learn all the lessons of the crisis. We have already Introduced EU-wide rules for better supervision and increased transparency in the credit rating market. This was an important first step. But we need to think about step two: the role of ratings themselves and the impact they can have on markets. Today, we are launching a consultation where we ask all the questions that need to be asked. The feedback we get will help us determine what further action is needed."

On 7 December 2010, a new EU regulatory framework applicable to the credit rating sector will come into force. New rules will require credit rating agencies to comply with rules of conduct in order to minimise potential for conflicts of interest, ensure higher quality ratings and greater transparency of ratings and the rating process. (See IP/09/629).

However, learning lessons from the recent euro debt crisis, some issues related to credit rating agencies still need to be sorted out. The consultation launched today asks a whole series of questions to gather views from all stakeholders on possible initiatives to strengthen the regulatory framework further for credit rating agencies.

Questions asked include:

- Overreliance: the recent euro debt crisis has renewed concerns that financial institutions and institutional investors may be relying too much on external credit ratings. The question should be asked as to whether it is right that European and national legislation refers to credit ratings, thus giving them a very important role, and whether alternatives could exist. The Commission therefore asks which measures could reduce this possible overreliance and increase disclosure by issuers of structured finance instruments in order to allow investors to carry out their own additional due diligence on a well-informed basis;

- Improving sovereign debt rating: sovereign debt ratings play a crucial role for the rated countries, since a downgrading has the immediate effect of making a country's borrowing more expensive. Given the importance of these ratings, it is essential that ratings of this asset class are timely and transparent. While the EU regulatory framework for credit ratings already contains measures on disclosure and transparency that apply to sovereign debt ratings, further measures could be considered to improve transparency, monitoring, methodology and the process of sovereign debt ratings in EU;

- Competition: Only a handful of big firms make up the CRA sector. There are high barriers to entry. Concerns have been expressed that the rating of large multinationals and structured finance products is concentrated in the hands of only a few CRAs. This lack of competition could negatively impact the quality of credit ratings. The Commission asks what options exist to increase diversity in this sector;

- Liability: the rules on whether and under which conditions civil liability claims by investors against credit rating agencies are possible currently vary greatly between Member States. It is possible that these differences could result in CRAs or issuers shopping around, choosing jurisdictions under which civil liability is less likely. The Commission asks whether there is a need to consider introducing a civil liability regime in the EU regulatory framework for CRAs;

- Conflicts of interest: The "issuer-pays" model raises questions of conflict of interest. This model is when issuers solicit and pay for the ratings of their own debt instruments. This model is the prevailing model among CRAs. As rating agencies have a financial interest in generating business from the issuers that seek the rating, this could lead to assigning higher ratings than warranted in order to encourage the issuer to more business with them in future for example. It may also lead to practices of "rating shopping", which is when an issuer chooses a CRA on the basis of its likely rating. The Commission asks what evidence there is for such practices and whether alternative models would be possible.

On the basis of the replies to the consultation, the Commission will decide on the need for any measures in 2011.

More information:


Concentration of OTC Derivatives among Major Dealers (ISDA)

Abstract: U.S.-based derivatives dealers account for 37 percent of the global total notional amount outstanding of derivatives reported by Survey respondents. The largest fourteen derivatives dealers (G14) hold 82 percent of the total notional amount outstanding. Broken out by products, the G14 group holds 82 percent of interest rate derivatives, 90 percent of credit default swaps, and 86 percent of equity derivatives. Evaluated by traditional measures, concentration of notional amounts among major dealers appears to be low.

The full report: www.isda.org/researchnotes/pdf/ConcentrationRN_4-10.pdf

Monday, November 1, 2010

Credit Risk Transfers and the Macroeconomy (ECB)

Abstract: The recent financial crisis has highlighted the limits of the "originate to distribute" model of banking, but its nexus with the macroeconomy and monetary policy remains unexplored. I build a DSGE model with banks (along the lines of Holmström and Tirole [28] and Parlour and Plantin [39]) and examine its properties with and without active secondary markets for credit risk transfer. The possibility of transferring credit reduces the impact of liquidity shocks on bank balance sheets, but also reduces the bank incentive to monitor. As a result, secondary markets allow to release bank capital and exacerbate the effect of productivity and other macroeconomic shocks on output and inflation. By offering a possibility of capital recycling and by reducing bank monitoring, secondary credit markets in general equilibrium allow banks to take on more risk.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1685771