Executive summary Techniques for transferring credit risk, such as financial guarantees and credit insurance, have been a long-standing feature of financial markets. In the past few years, however, the range of credit risk transfer (CRT) instruments and the circumstances in which they are used have widened considerably. A number of factors have contributed to this growth, including: greater focus by banks and other financial institutions on risk management; a more rigorous approach to risk/return judgments by lenders and investors and an increasing tendency on the part of banks to look at their credit risk exposures on a portfolio-wide basis; efforts by market intermediaries to generate fee income; a generally low interest rate environment, which has encouraged firms to search for yield pickup through broadening the range of instruments they are prepared to hold; and arbitrage opportunities arising from different regulatory capital requirements applied to different kinds of financial firm. The significance of CRT seems to vary appreciably across firms and market segments. Thus, for example, the intermediation of credit default swaps seems to be a major business line for a small, but only a small, number of firms; and CRT markets are particularly active for major company credits, much less so for SMEs. Given these differences, it may be misleading to talk about the overall impact of CRT. However, while CRT flows have been substantial, and despite recent growth, CRT activity seems still to be relatively small compared with the outstanding stocks, and even the current flows, of credit-riskrelated instruments. After setting out some of the broader background (Section II), this Report reviews the recent development of CRT markets, describing the characteristics of the instruments used, the nature of the market participants and the reasons for their involvement (Section III). It then discusses some of the principal features of the markets themselves, focusing on the questions of transparency and data availability, on how CRT instruments of different kinds are priced and on how far the existence of CRT markets has affected the process of price discovery (Section IV). The remainder of the Report (Sections V, VI and VII) identifies and analyses some possible implications of the evolution of CRT markets for the overall functioning of the financial system and discusses some of the concerns which have been expressed about the impact of CRT on financial stability. CRT instruments typically change the relationship between borrowers and lenders and establish new relationships between lenders and those to whom they may pass on credit risk (Section V). This implies in particular changes in the incentives which the different parties to a credit transaction face. The Report analyses these changes in terms of potential market failures, for example asymmetric information, principal/agent problems and incomplete contracts. It concludes that most of these problems have been recognised by market participants and market authorities and have been addressed in one way or another. In some cases, however, it has proved difficult or impossible to arrive at an entirely satisfactory solution. One common approach is to ensure that the risk shedder retains some interest in the performance of the borrower and therefore some incentive to monitor the borrower’s performance carefully. Such retention can, however, diminish the attraction of CRT transactions in so far as regulators may not recognise the risk transfer for capital requirement purposes unless it is complete. A further problem has proved to be the formulation of contracts in a way which is unambiguous in all plausible circumstances. In a number of cases a situation has arisen which was not anticipated at the time a contract was drawn up and in which the interests of the parties to the contract have diverged. At one level this is a legal/documentation issue, and some worthwhile progress has been made, in this and in other areas, by developing the standard ISDA contract. Further improvements could no doubt be introduced. Some especially difficult issues arise, however, in relation to the definition of "restructurings" and their inclusion as credit events. At present it is not clear how far these are capable of being resolved by legal drafting and how far they reflect deeper problems of contract design. In any case, there remains a concern that those who believe they have shed risk could sometimes find that they have not, and that those who believe they are not at risk may find that they are. The Report considers (in Section VI) some structural implications of the wider use of CRT. In particular, it notes that rating agencies play a central role in some CRT markets. To an extent this is no different from the role which they already play in the rating of corporate debt (and indeed the market in single name credit derivatives is, broadly speaking, confined to names which are already rated). But the rating agencies arguably have an even more important role in relation to portfolio instruments, and their models have set market standards for credit risk assessment of such instruments. While the analytical basis for these assessments has been advancing, there are still some significant unresolved questions, notably about the way diversification effects should be handled. This in turn implies some uncertainty about the pricing of the instruments themselves. CRT also has a potentially major impact on the way that banks go about their business. Increasingly, they are acting as credit originators rather than long-term funders, shifting loans off their balance sheet either individually or as part of a package through loan transfers and securitisation. In some cases, however, they continue to act in an agency capacity in terms of monitoring and servicing the loans. While these trends now seem firmly established, they have so far had only a relatively small impact on the profile of business for the banking sector as a whole, with a possible exception in the area of credit card receivables and mortgages in some countries. Innovation in financial markets, and within that the development of new financial instruments such as credit derivatives, is generally to be welcomed as increasing market efficiency, enabling better diversification of portfolios and providing a wider range of techniques for risk management. However, there are a number of aspects of CRT which raise policy issues and which, at least in some cases, might point to the need for a policy response (Section VII). Some of the main ones are as follows: Transparency - financial firms’ disclosure of their CRT activities is patchy at best. In a fastdeveloping market with a potentially significant effect on the distribution of risks this lack of disclosure is a concern. The Report suggests that the issue might best be addressed by lending support to existing initiatives on disclosure (eg Fisher II) and by flagging the specific concerns in relation to CRT. Aggregate data - the relative dearth of information at the level of the individual firm is paralleled by an incomplete picture of how CRT markets are developing in aggregate. Central banks and others are currently exploring how to improve their database related to CRT instruments without imposing an undue reporting burden on market practitioners. Rating agencies - the Report notes the critical role of rating agencies in various CRT markets and the implicit reliance on the risk assessment techniques which they use. Although the Report does not formulate any view on the desirability or otherwise of this state of affairs, the CRT dimension should be taken into account in the various reviews of the rating agencies’ activities which are at present in progress. Diversification and concentration - one of the principal potential benefits of CRT is that it facilitates the wider dispersion of risk and allows risk profiles to be adjusted more flexibly. At the same time, some elements of the CRT market appear to be highly concentrated, which might give rise to market disruption if the firms concerned were to come under pressure. Contract design - as previously noted, the formulation of restructuring clauses in credit derivatives contracts has proved to be particularly problematic. It remains to be seen whether the difficulties can be resolved; if not, it could act as a significant brake on the further development of this part of the CRT market. Risk management - although in many respects CRT involves familiar risk management issues, it does sharpen questions about counterparty risk in relation to unfunded risk transfers, given the speed and scale of possible changes in exposures, and also raises technical questions about the reliability of pricing of portfolio instruments. In addition, there are a number of issues related to documentation on which further work is needed. More fundamentally, there has been concern that CRT could lead to a weakening in overall credit risk monitoring if those who end up holding the credit risk have less information about the borrower than the original lender. Market practice has, however, evolved in a number of ways to mitigate this risk. Accounting - divergences in accounting rules have had a restraining effect on certain parts of the CRT market. As credit risk (at least vis-à-vis larger borrowers) becomes more readily tradable, it may also increase the tension between book value and mark to market valuation. Although the Report did not explore this (contentious) issue it is clear that it is attracting increasing attention from practitioners. Regulation - CRT has the potential to highlight more clearly differences in the regulatory treatment of credit risk as between different kinds of institution and is, therefore, likely to work towards a more integrated approach to regulatory capital standards. The International Association of Insurance Supervisors and the UK Financial Services Authority have recently reviewed the regulatory implications of CRT.