Credit risk transfer by EU banks: activities, risks and risk management

The European Central Bank (ECB) is today publishing a report on the credit risk transfer (CRT) activities of EU banks. The report was prepared by the Banking Supervision Committee (BSC) of the European System of Central Banks, which comprises of representatives from the ECB and the national central banks and banking supervisory authorities of the EU.

The report examines the activities of EU banks in CRT markets and the risks they face there. CRT instruments are products which allow credit risk to be transferred from its original holder to investors. These instruments can also be actively traded. Traditional CRT instruments such as financial guarantees and credit insurance products have been available for some time. The report focuses on novel and complex instruments, above all credit derivatives and collateralised debt obligations (and their variants), which permit the unfunded transfer of credit risk in very large amounts and in a way not seen before. The markets for these instruments have grown very rapidly over the past few years.

The report is the most comprehensive survey undertaken to date by supervisors and central banks on the use of CRT instruments and covers over 100 banks from the 15 countries which constituted the EU before 1 May 2004, as well as five large non-EU banks and securities houses operating in London. The BSC is responsible for continuously monitoring the sources of risk that banks face and, more generally, for assessing banking stability and exploring measures that might be warranted to maintain financial stability. It is to this end that it has collected information on the CRT markets.

Scale and scope of CRT activity. For the majority of banks surveyed, the importance of CRT instruments remained relatively limited. However, several banks made significant use of them. Risk shedding or risk taking through the CRT markets amounted in some instances to more than 10% of the bank’s total assets. The banks that used CRT instruments for portfolio management purposes were reported as dealing mostly with large intermediary banks. London was reported as being the main international centre for CRT activity.

Net risk transfer through CRT markets CRT activity was found to be increasingly a bank-to-bank business. At the time the survey was conducted, there were signs that the investment appetite of some insurance companies that had earlier entered the market was on the decline. On the other hand, the involvement of hedge funds was reported as increasing.

Functioning of CRT markets. In general, banks considered CRT markets to be functioning well. Interviews with major market participants indicated that the rapid pace of growth and innovation continued in 2002 and 2003 and that market liquidity had improved markedly. Significantly, however, there was a widespread perception among the banks interviewed that CRT markets remained opaque. The potential for disruption of the CRT markets was, in general, considered to be small. Nevertheless, some sources of risk that could potentially pose challenges to market functioning were identified. These included the possibility of a major counterparty leaving the market, a large credit event leading to settlement difficulties, or fraud leading to a loss of confidence in the market.

Risk management. Existing risk management tools (internal and external ratings, market-based estimates of probability of default and credit portfolio models) were largely regarded as being adequate as long as a bank’s CRT activities remained relatively limited. By contrast, banks involved in the intermediation of complex CRT instruments in large volumes said they required sophisticated risk management systems. These banks reported having put in place such systems based on enhanced risk models and information technology.

Business models and strategies. CRT instruments facilitate the trading of credit risk, thus blurring the borderline between banking and trading books. According to the banks surveyed, resulting changes in business models and strategies have not been dramatic so far. However, they foresee important developments in the future, as CRT activities are expected to continue growing at a fast pace. For instance, the traditional strategy of granting and holding loans will tend to shift towards attracting loans and transferring them to the parties most willing to bear the risk and a more integrated approach to credit risk assessment and management is likely to develop.

Supervisory authorities and central banks are paying increasing attention to developments in this market, while recognising the benefits of CRT for financial stability. Most importantly, CRT instruments allow banks and other financial institutions to diversify their risks in more effective ways. Further work to examine linkages across the sectors of the financial system is also ongoing in other European and international fora.

This report can be downloaded from the “Publications” section of the ECB’s website (http://www.ecb.europa.eu). Printed copies are also available free of charge from the ECB’s Press and Information Division (info@ecb.int, fax: +49 69 1344 7404).