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The increasing ability to trade credit risk in financial markets has facilitated its dispersion across the financial and other sectors. However, specific risks attached to credit risk transfer (CRT) instruments in a market with still-limited liquidity means that its rapid expansion may actually pose problems for financial sector stability in the event of a major negative shock to credit markets. This paper attempts to quantify the exposure of major U.K. financial groups to credit derivatives, by applying a vector autoregression (VAR) model to publicly available market prices. Our results indicate that use of credit derivatives does not pose a substantial threat to financial sector stability in the United Kingdom. Exposures across major financial institutions appear sufficiently diversified to limit the impact of any shock to the market, while major insurance companies are largely exposed to the "safer" senior tranches.
This paper shows under which conditions loan securitization, e.g. collateral debt obligations (CDOs) of banks can increase the systemic risks in the banking sector. We use a simple model to show how securitization can reduce the individual banks' economic capital requirements by transferring risks to other market participants and demonstrate that systemic risks do not decrease due to the securitization. Systemic risks can increase and impact financial stability in two ways. First, if the risks are transferred to unregulated market participants there is less capital in the economy to cover these risks. And second, if the risks are transferred to other banks interbank linkages increase and therefore augment systemic risks. We analyze the differences of CDOs (true sale) and credit default swaps (synthetic) in contributing to these risks. An empirical analysis finds a significant relationship between systemic risk and CDO issuance for monthly data for the years 2000 until 2005.
The paper discusses the limits to market-based risk transfer in the financial system and the implications for the management of systemic long-term financial risks. Financial instruments or markets to transfer and better manage these risks across institutions and sectors are, as yet, either nascent or nonexistent. As such, the paper investigates why these markets remain "incomplete." It also explores a range of options by which policymakers may encourage the development of these markets as part of governments' role as a risk manager.
We review the limited available literature relating to markets for credit risk transfer. These markets help to complete incomplete financial markets for credit risk by facilitating the isolation of credit risk from other risks and extending the opportunities to manage credit risk. Yet, CRT markets give rise to additional risk management problems, and they also create new asymmetric information problems. Pricing for some CRT instruments also remains difficult. We identify the new problems created by CRT markets in terms of their effects on relationships between borrowers and lenders and between lenders and credit protection sellers. We also discuss how different forms of CRT instruments or contracts mitigate the problems to differing degrees. Finally, we identify three channels through which CRT markets may have financial stability implications: Firms' access to finance; monetary-policy-transmission mechanisms; and interactions between markets.
We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank. CDS contracts may be used to hedge a bank's credit risk exposure at a certain (potentially distorted) price. Regulation is found to induce the risk-neutral bank to behave in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loansincreases. CDS trading is found to interact with the former effect when regulation accepts CDS as an instrument to mitigate credit risk. Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased. However, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased. This promotes the intention of the Basel II (and III) regulations to 'strengthen the soundness and stability of banks'
The globalisation of financial markets has attracted much academic and policymaking commentary in recent years, especially with the growing number of banking and financial crises and the current credit crisis that has threatened the stability of the global financial system. This major new Research Handbook sets out to address some of the fundamental issues in financial regulation from a comparative and international perspective and to identify some of the main research themes and approaches that combine economic, legal and institutional analysis of financial markets. Specially commissioned contributions represent diverse viewpoints on the financial regulation debate and cover a number of new and controversial topics not yet adequately addressed in the literature. Specifically, these include; financial innovation particularly in the context of the credit risk transfer market, securitization and the systemic importance of the over-the-counter trading markets; the institutional structure of international financial regulation; and risk management and corporate governance of financial institutions. This Handbook will provide a unique and fully up-to-date resource for all those with an interest in this critical issue including academic researchers in finance and regulation, practitioners working in the industry and those involved with regulation and policy.
Until about twenty years ago, the consensus view on the cause of financial-system distress was fairly simple: a run on one bank could easily turn to a panic involving runs on all banks, destroying some and disrupting the financial system. Since then, however, a series of events—such as emerging-market debt crises, bond-market meltdowns, and the Long-Term Capital Management episode—has forced a rethinking of the risks facing financial institutions and the tools available to measure and manage these risks. The Risks of Financial Institutions examines the various risks affecting financial institutions and explores a variety of methods to help institutions and regulators more accurately measure and forecast risk. The contributors--from academic institutions, regulatory organizations, and banking--bring a wide range of perspectives and experience to the issue. The result is a volume that points a way forward to greater financial stability and better risk management of financial institutions.
This paper discusses the impact of the rapid adoption of artificial intelligence (AI) and machine learning (ML) in the financial sector. It highlights the benefits these technologies bring in terms of financial deepening and efficiency, while raising concerns about its potential in widening the digital divide between advanced and developing economies. The paper advances the discussion on the impact of this technology by distilling and categorizing the unique risks that it could pose to the integrity and stability of the financial system, policy challenges, and potential regulatory approaches. The evolving nature of this technology and its application in finance means that the full extent of its strengths and weaknesses is yet to be fully understood. Given the risk of unexpected pitfalls, countries will need to strengthen prudential oversight.