Special Report Regulating Credit Default Derivatives Introduction Te ongoing global economic crisis has forced governments and central banks around the world to rethink the role of regulation to prevent a crisis of this magnitude in future. The G-20 summit in London this year probably provides concrete evidence about the seriousness with which nations plan to handle the current downturn with stringent rules for the financial sector to move forward. In particular, there seems to be a growing consensus among, policymakers about the role played by sophisticated financial instruments and institutions in bringing about the downturn and posing a systemic threat to the health of the financial sector as a whole. The official communiqué of the G-20 summit, not surprisingly then, calls for greater regulation of hedge funds, tax havens, and shadow banking systems to curb or prick any future bubbles emanating out of the financial sector. While bringing hedge funds and tax havens (and other such institutions) under greater regulation should be seen as a welcome move, the present situation should also be viewed as an opportunity to restructure and redesign financial markets in a way in which innovation and the rate of innovation in such markets pose more of an opportunity for the real economy than being a threat, as has been witnessed in the context of the present crisis. An example of such a threat is the crash in the financial sector in general, which many believe was brought about by the rise and fall of credit derivatives (Credit Default Swap-or CDS—type). Given this background, this article looks at how innovation in the derivative space has reshaped the role of banks and the role regulation can play in preventing such crises in the future, 74 | Commodity Vision | Volume 3 I sue 2 Sep-Oct 2008 Madhoo Pavaskar and Bhuvan Sethi Though the whole financial sector came into being to act as an intermediary or a conduit t0 channel money from investors to borrowers, @ peculiar characteristic of these markets, which we ofien choose not to acknowledge, is that everyone sees them as engines of wealth creation and nobody likes markets to correct themselves. Investors are increasingly seeing financial markets as a one- way street leading to nothing but greater return on inyestments. Regulation only plays its part by ensuring that wealth creation is done through Jawful means and that no player in such markets uses inside information or unlawful means to attain wealth at the cost of others. The buck stops here. The whole concept of market share and outperforming the markets has led the industry and the people who run it to search for that magical yield (higher than normal rate of return) by circumventing the existing, regulatory structure. To tell the truth, the alleged culprits (hedge funds and tax havens) actually were Jjust mot there a few decades back, but have only ‘come up in response to certain regulatory loopholes that allow investors to gain that extra bit of profit The last decade or so has witnessed a similar kindof “regulatory circumvention’ n (as explained in ch, it in the form of credit securitizat urse of this article), anchecked of banking Securitization of Credit Default Risks nile securitization of credit as a means to t redit risk has been going on for long, easing credit m now has le edit to the sub-PLR? category of ins in the Western economies! for little anks to extend than a decade while all this was happening, nobody seemed to b bothered about the default risk that was building in the credit markets, Borrowers were using such ets like housing, loans to buy tangibl ‘conomy boost to the real aking credit for were hap B the! Competition among banks e Bcd to undercutting each othe to sub-prime borrowers and earning nd more loans, y since they were able to charge high in disbursing loans more profit his is where by extending more securitization in handy Generally speaking, io of | securitization allows banks ns into a trust and then ated by bond nand were to transfer a portf have that trust issue securities oF fencies and purchased in market. In this way, banks on the one xtending credit to borrowers with poor cred history, and on the other hand bundling up such loans into complex structured products and selling them in the market as asset backed securities (ABS) Other financial institutions like pension fu insurance companies, hedge funds, and invest vity by actin he benefit of vehicles lend support to such an ac as counterparties. However, with hindsight, we can now say that banks primarily used securitization strategy to raise funds more fo! lending than for tra risks in the marke Since most banks follow the Basel-I accord in terms of minimum capital reserve requirements, securitization allowed banks to lend more credit without actually raising their reserve requirements. a two-bank model where Bank A has $900 loans outstanding and Bank B has none. Both banks hold $1000 as deposits and $100 as capital reserve 'o get a clear picture, consider Special Report Step-I: Bank A creates an ABS for $900 and sells it to the depositor at Bank B, a 1000/0 00 8 10/0 100 ! cumulative ‘ABS=$900 Step-Il: Bank A now has no outstanding loan and can lend up to its limit determined by the capita reserve. The amount gets deposited with Bank B. Bank Capital reserve * 100 wee 100 Cumulative 185=5900, Step-III: Creating an ABS results in both the banks getting back to their starting points with the only difference being ABS worth $900, Now Bank A can continue lending by creating ABS till the time it is able to find buyers for its ABS and Bank A again securitizes and sells it to Bank B. its portfol Rank Deposits | lean Outstanding | Capital Reserve A [000 [0 100 8 10/0 100 Cumulative T /A85=51800 redit allowed banks to Not only did create an infinite loop of lending. panks to play ni ider sense it also diluted the According to the theory of financial n put forward by Diamond’ and Leland and Pyle," banks primarily exist to address information asymmetries in credit markets. While n the one hand banks are supposed to perform the screening function from the bad, on the other hand they monitor loan disbursements to curb any opportunistic behaviour by the borrower intermediati On a more macro level, the screening and monitoring functions of banks ensure that the overall quality of borrowers remains healthy by providing incentives for goodSpecial Report behaviour-something thought to be essential for lowering individual and systemic eredit risk However, these theoretical underpinnings were also based on the notion that banks would like to hold their assets (loans) till maturity and would, thus, sereen and monitor borrowers. Subsequently, any increase in bank lending would have to be primarily? supported by growth in deposit base and adjustments to capital reserve. The process of securitization changed all this as banks could now originate and distribute loans rather than warehouse such risks till maturity (refer to the earlier example) As such, this not only freed banks from screening and monitoring borrowers, but also made perfect business sense as banks saw securitization as an alternative to the traditional way of funding their lending business. In fact, banks found It convenient and more cost effective to securitize existing credit lines than incur the cost of raising deposits (in terms of CRR and SLR maintenance, operational costs, and provision for non-performing assets among others). Plus, the traditional way of raising money would have also meant banks diluting their capital structure further!”—which is both costly and subject to mindset limitations. Overall, securitization had a threefold impact on credit markets: first, securitization partly worked as an alternative to the traditional deposit taking exercise for raising funds; second, it allowed, banks to transfer credit risks to other financial institutions looking for risk diversification; and third, on an aggregate level, the secondary market for Credit Risk Transfer (CRT) also doubled up as an indicator for prevailing credit conditions and pricing of marginal credit. Paradox of CDS Market In practice however, the market failed to achieve any of these benefits. On the matter of redistribution of risk, the design and investment horizon of financial institutions created a problem. Specifically, while banks created the demand for protection buying, the supply or protection selling came from other non-bank intermediaries like pension funds, insurance firms, hedge funds, and other smaller banks, However, the investment horizon of such intermediaries required them to either hold the asset till maturity (like in the case of pension funds and insurance companies) or to trade the instruments Vision! Volume 3 Issue 21 Sep-Oct 2008 in the market (like hedge funds and mutual funds} Also, since non-bank financial intermediaries were primarily in the market for portfolio rebalancing and risk diversification, none of the players was able to perform the role of a market-maker. This proved to be both a compulsion (to make the secondary market more liquid) and an opportunity (Fee income from intermediation) for banks to intermediate in the market. Infact, a survey conducted by the European Central Bank in May 2004! revealed just this. On being asked about the motivation of European banks to be involved in the market for credit risk transfer, majority of them stated similar motivation as given in this article. Highlights of the survey are mentioned below On the buy side, banks were motivated to originate CRT instruments to play regulatory arbitrage, improve acces to funding via collatcral made available by securitization followed by need to manage individual credit lines. In some countries, securitization was driven by funding and liquidity needs ‘On the sell sid, primary motivation for banks to use CRT was to diversify risk and seck an alternative profitable asset class. Some banks also viewed CRT business to be more attractive than the orthodox credit business as it provided higher margin income On the intermediation front, banks were in the market to ear fee income and broaden the services offered to their customers. Moreover, bankers saw the intermediation role growing in future as corporations and governments were increasingly looking at entering the market Moreover, to squeeze maximum value out of these credit derivatives, banks resorted to structuring these derivatives into tranches and complex products, (like collateralized debt obligations (DO) and synthetic CDOs). In fact, at the time this surv carried out, risk management through structured products reached as high as 30% of the total asset base. On an aggregate level therefore, banks with wider and more heterogeneous customer base and broader activity (lending, investment banking, and asset management) experienced scale economies in making two-way trade in this market, Credit diversification by smaller banks was further narrowed down by their inability to originate CRT instruments owing to their balance sheet constraints (like non-rated SME loans). Bigger banks also estspitalized on their geographical advantage by engaging in cross-country CRT instrument trading, In effect, the CRT market progressively became a bank-to-bank market or rather a market for big universal banks only. Not only did this concentrate risk in the hands of few big banks operating across eographies, but the slicing and dicing of securitized credit meant that banks were ultimately retaining a part of such structured products (usually the first equity tranche) on their balance sheet and at the same time transferring the safer and thus more attractive senior and super-senior tranches to investors. This not only defeated the purpose of risk diversification, but the structuring and restructuring of products made it difficult for market participants to account for the amount of aggregate risk these banks and other institutions were holding. Figure 1 shows the mark-to-market losses for various financial institutions in the U.S. as in April 2008. Figure 1. Mark-to-market losses for financial institutions in the US. (billion $) ‘Source IMF Gabo Fnac! teity Rep, Octaber 2008 Second, the issue of credit derivatives acting as an indicator of prevailing credit conditions also went awry as most investors did not take positions in the physical market (corporate bonds, etc.). In other words, the provision of naked shorting resulted im many viewing this segment of derivatives as an asset class rather than as a platform for hedging Moreover, the embedded risk in such contracts created direct linkages with equity markets, providing investors (mainly speculators) with the option of using short-sell strategies, heightening market abuse. Finally, and most importantly, credit derivatives also somewhat failed to convince the market of the level of intrinsic risk that was building up during the run up to the meltdown. Credit markets, as early as in 2006, were showing signs of distress with spreads in inter-bank funding going up, rising defaults in U.S sub-prime, etc., yet the CDS spread’ was at a historically low level. While a part of this risk ignorance can be attributed to the irrational exuberance guiding the financial markets during much of 2006-early 2007, the almost sudden vertical jump in the CDS spread post-April 2007, and especially the inverse relationship between the composite time series of selected financial firms’ CDS" spread and the market capitalization index Of selected banks" (Figure 2) was actually an early warning for the Federal Reserve Authority (Fed) to act. Had the Fed acted then to reduce interest rates swiftly, the crash in the financial market could have possibly been avoided. After all, almost 300% increase in the CDS spread between April and August 2007 was significant enough to raise an alarm on the growing risks in the CDS market Unfortunately, for want of data perhaps, the Fed appears to have ignored the distress signal. Quick action was then needed to bolster up the banks with appropriate bailouts and cheap supply of credit to curb them from needlessly securitizing their sub- prime assets, besides resorting to strict monitoring and regulatory actions on them by the Fed. Be that is it may, it appears from Figure 2" that it should not be difficult for the authorities to gather fitting data to devise an analytical mechanism that can ring the alarm bell Figure 2. Composite time series of select financial firms’ (CDS and share prices Source: Turner Review:A Regulatory Response to Globo Franco Criss Commodity Vision | Volume 3 sue 2| Sep-Oct 2009 Special ReportSpecial Report Regulatory Recommendations Credit securitization can perhaps easily pass off as orld of tinance as it provided an answer to the longstanding issue of liquidity mismatch for banks and other financial institutions. Yet, as with many other financial instruments, most banks and financial institutions have somehow cared little for their utility to meet the unavoidable short-term exigencies and, instead, used these instruments as a means to gain wealth by creating greater risks and hazards. It is for sure that banks used securitization primarily to raise funds for lending to uncreditworthy borrowers on sub-prime assets, without caring really about the risk transfer aspect of CDS. In effect, the means to transfer risk actually turned into a means to accumulate further risks for not only the bank creating such means in the first instance, but also for the entire financial sector as well. Hence, such innovation in the financial sector poses some tough ators. Should securitization one of the great innovations in the questions for the r be banned altogether, or should such instruments be regulated severely? Expectedly, a wide spectrum of views and counterviews are doing the rounds, with some going as far as to suggest an absolute ban on credit derivatives, while others advise product regulation However, any regulatory response to financial market crises cannot be a single-point solution and has to be a bouquet of solutions. Therefore, on the regulatory front, regulators should not just focus on how the markets need to function efficiently. but also on how much wealth can be created by lhe mathels on a sustainable basis. In other words, regulators should also focus on how much leverage generated by credit derivatives is too much. True this is not an easy task. Yet, as stated earlier in the article, the authorities should devise an analytical tool that optimizes the CDS spread in relation to the share prices of the CDS creating agencies or institutions. This does not seem to be an impossible task Second—and probably another important thing this meltdown has taught us—over-the-counter (OTC) derivatives need solid disclosure norms. Contrary to popular beliefs, it was not securitization alone that brought down the markets, but opaque pricing of structured products and lack of data on market deals also helped markets on their way down, Moving 72 | Commodity Vision | Volume 3 Issue 2 Sep-Oct 2008 the OTC derivative to exchange traded derivatives is one option, but it needs to be debated whether product standardization would work for ot against the industry. Nevertheless, moving OTC derivatives to exchanges would bring four benefits to the table: systemic risk, pricing transparency and counterparty risk, authority to limit market abuse (naked shorts) id investor protection. Again, it is not as simple as it seems to standardize the OTC credit derivative products. For one thin the OTC products are customized and tailor-made meet the market requirements, On the other hand, i s difficult for the institutions creating such products (0 submit themselves to clearing and mark-to-market regulations voluntarily. Any attempt to enforce such market regulations will simply drive such trade underground, worsening the scenario further, On the industry front, banks and other institutions have burnt their fingers and can, no doubt, be expected to learn from their past and avoid such mistakes in the future. Yet, as the history of business cycles has time and again shown, lessons of histo as fast as they are learnt. Small wonder, history repeats itself. Markets undoubtedly create wealth most of the time. The estructive power of the market~it rarely lashes out. re forgot though-is also quite fierce, however. Therefore, just as flood control measures are necessary to harness the benefits of river water, market regulation is required to secure the market gains. As the current crisis has shown, markets cannot be relied upon to correct themselves. The authorities should have adequate discretionary powers to scrutinize the asset portfolio of banks as and when they think desirable. Vesting such powers with the authorities will more often than not prove to be an adequate threat to the banks to avoid assuming financial risks disproportionate to their capital and normal liquidity norms in terms of cash treasury securities Incider cchits, and even AAA ratings, to the securities ade in the CDS market are as much responsible for the global financial meltdown as the banks and othe institutions that created such securities. Clearly, ly. the rating agencies that gave clean rating agencies are now under cloud in the sa way as accounting and audit firms were after the Enron crisis. It follows that the rating agencies need to be regulated, too, by making them accountableSpecial Report s with penal provisions for fraudulent critically the need for prescribing sound norms fi for their ratin Jigent actions on their part. Such regulatory di n ferent types of assets in the portfolios of banks, provisions would go a long way in ensuring better relative to both their equity capital and liquidity Serutiny of rated securities, a also result in a much in terms of their cash reserves and investments in more resilient derivatives marke certain designated liquid securities. Yet, another regulatory step essential to aver the CDS trap, in which banks and others found Conclusion themselves, is for the Fed and other central banks of Nevertheless, when all's said and done, there is n the world to raise considerably the capital adequacy _gainsaying that the regulatory recommendations norms prescribed even under Basel Il, which have proposed in this article are in the nature of a urned out to be inadequate in the wake of the priori suggestions that call for close and careful collapse of major financial institutions in the U.S. ¢xamination by the authorities and other financial and elsewhere, experts to assess their implications on the growth This is not all. The Fed and other similar of banks in general, and the financial sector in uuthorities the world over should also consider particular \dhoo.pavaskar@taerindia.com, bhuvan.sethi@taerindia.com Nor part from expansio ste monetary expansion in the U.S, global popularity of U.S treasury bis and the status Ch as the reserve currency helped create excessive liquidity in the US financial system, further incentivizing Ass lea Refers to people with poor credit history or repayment capacity 4. Adapted i let, “The Infinite Loan Machine: An Examination of the Effect of Loan Securitization on the Fractional atory arbitrage refers to a regulated institution taking advantage of the difference between its real economic risks and the rel sition. (Wikipedia) D. Diamond, “Financial Intermediation and Delegated Monitorin nomic Studies, Vo. 51, 1984, pp. 393-414. 8 HE Leland and Dl. Pyle, “Informational Asymmetries, Financial Structure and Financial Intermediation,” Journal ising money include inter-bank borrowing and Issuance of debt. However, commercial hanks ma apital structure refers to how a corporation raises funds to finance its assets, Capital structure typically comprises a mix feb, equite ne hybrid securities, 1. “The Influence of Credit Derivative and Structured Credit Markets on Financial Stability,” Global Financial Stability Report IME 20 edit Risk Transfer by EU Banks: Activites, Risk and Risk Management” A Survey of EU Banks, ECB, 2004 3. The spread on CDS is the annual amount a protection buyer must pay the protection seller over the length of the contract, 4. cos ep contract where the buyer pays a periodical fee to the protec and receives a pay-off in the € ne underlying fim. experiences a default, a restructuring, or even a rating downgrad 15, Firms include Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway, Bradford& Bingley, Citigroup, Deutsche an Stanley, National Australia Bank, Royal Bank of Scotlan Bank, Forts, HBOS, Lehman Brothers, Merrill Lynch, M Turner Review: A Regulatory Response to the Global Financial Crises” FSA, March 2009,