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Risk retention and how to regulate it

Thursday 1 September 2011 - by Kim Shafer

Measures to moderate bubbles by improving information and aligning interests through revenue and compensation can better achieve the objectives of credit risk retention, says Kim Shafer, senior fellow at the Center for Financial Stability.

Risk retention makes intuitive sense. If a securitiser has ongoing risk of loss, typically referred to as "skin in the game", then that party will presumably originate loans with greater care.

If loan quality improves, risks within the financial system might diminish, but the law of unintended consequences suggests what is intuitively appealing may turn out to have the opposite effect.

The Dodd Frank Act mandates risk retention for securitised products and charged six regulators with crafting implementing regulations, adapted for each different securitised asset.

As a senior fellow of the Center for Financial Stability and a prior market participant, I submitted comments to these regulators on risk retention and collateralised loan obligations (CLOs, which are securitisations of syndicated leveraged loans) suggesting appropriate draft regulations for CLOs, but also concluding that alternative measures could be more effective with less risk.

CLOs are an interesting example because they are similar in construction to the ABS CDOs that proved so devastating in the financial crisis. Yet, CLOs and leveraged loans crashed in price during the financial crisis but did not burn; less than a handful defaulted and their market pricing largely recovered, as default rates on the underlying loans normalised after a spike.

For a more extensive discussion of the parallels and differences between ABS CDOs and CLOs, how CLOs exacerbated the loan bubble, and more extensive comments on the proposed regulations, see this CFS paper here.

Similar to mortgages, the institutional segment of the leveraged loan market became an originate-to-distribute market; banks would syndicate loans on terms based on institutional investor demand and CLOs were over 60 per cent of that demand (in 2003 through the first half of 2007).

Loan quality deteriorated as the credit bubble grew, and CLOs by their nature exacerbated the bubble. The reasons CLOs exacerbated the loan bubble have everything to do with misaligned interests. The reasons they did not perform as disastrously as mortgages and ABS CDOs has everything to do with the relative quality and veracity of loan information in contradistinction to mortgage information.

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