Credit risk trading. An examination

Table of contents

1 Introduction

2 Classical banking and the transformation of the banking system

3 Credit risk transfer

4 Conclusion

5 References

List of tables and figures

Figure 1: Simplified balance sheet

Figure 2: Classification of risk-weights under Basel I

Figure 3: Calculation of risk-weighted assets and capital requirements

Figure 4: How securitization works

Figure 5: Credit default swaps

1 Introduction

In this paper, credit risk trading by financial intermediaries will be examined concerning the favoring of borrowers in form of a more extensive credit access for borrowers. In order to give a thorough understanding about credit risk transfer (CRT) and its motivation, in the following chapter there will be an overview over the classical banking system and its relevant changes until now. After that, different kinds of CRT and its advantages and disadvantages will be discussed to find a proper answer to the given hypothesis of enhanced credit volume as a result of these modern banking instruments.

2 Classical banking and the transformation of the banking system

To get a clear picture of the motivation and backgrounds of banks to sell credit risks, we will now take a look at the ‘basic retail bank’, a synonym for most of the British and US Banks operating between the 1950s and the 1980s (Unit 1 2016, p. 5). They relied on the fractional reserve banking model which evolved from the middle age, where money changers discovered that they could invest parts of their clients’ deposits in illiquid long-term loans to earn additional profits. Because the probability of a bank run, where every saver demands his deposit back, was very low, that system of keeping just a fraction of liquidity exposed itself as a very efficient form of banking (Rochet 2007, pp. 23f.). That kind of simplified balance sheet is shown in figure 1:

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Figure 1: Simplified balance sheet, source: Rochet 2007, p.23.

This pattern evolved further and was the foundation of the US saving institutions for about 200 years, where the basic purpose was the funding of home buildings within local communities – using the pooled savings of the neighborhood. ‘After one resident built a home and paid off the loan, it was another person’s turn to borrow’ (Crane/Bodie 1996).

The 1950s classical banking system based on the previously described basic retail bank model was characterized by low competition between banks. Interest rates and reserve ratios were set by the government. The key of bank management was the managing of credit risk on the asset side of the balance sheet to create a sustainable stream of income. If the loans were of good quality and properly monitored, public fears concerning losses of deposits could be avoided, leading to lower liquidity risk. Because of the their regional rootedness the bank managers could form deep client relationships and judge their capital servicing capacity (Unit 1 2016, pp. 6f.).

Between the 1960s and 1980s the banking system began to change noticeably. The first aspect of its transformation was the rise of interest rates, which made the existing long-term mortgages less profitable respectively drove their asset value down. Simultaneously, deposit rates were increased to attract more savers in a more competitive surrounding. So the rising rates led to serious liquidity as well as profitability problems for retail banks (Crane/Bodie 1996). The second aspect is also competition-based as more and more banks wanted to grow faster in order to achieve higher shareholder value. Though the previously mentioned government constraint concerning liquidity in form of a reserve ratio for bank assets as well the liability-limiting leverage ratios were hampering these efforts (Unit 1 2016, pp. 9f.). These regulations became stricter after the failure of some banks in the US in the 1980s as a result of excessive lending. To preserve system stability, the Basel I framework was established in 1988, setting a global standard for banks’ capital ratios, the measure of risk-weighted assets (RWA) to equity capital. Now, banks were forced to adjust their assets thoroughly concerning their risk-return-profile in order to not waste capital for high-risk assets (Zaher 2007). The classification of Basel I asset classes and an exemplary capital requirement calculation are presented in figures 2 and 3:

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Figure 2: Classification of risk-weights under Basel I, source: Zaher 2007.

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Figure 3: Calculation of risk-weighted assets and capital requirements, source: Zaher 2007.

It goes without saying that this framework combined with the increased competition led to a growing incentive to search for opportunities beyond the proper management of existing loans in order to overcome these constraints. The evolving credit activities outside of the banks’ balance sheet are discussed in the following chapter.

3 Credit risk transfer

The process of transforming private credit instruments, e.g. classical bank loans, into marketable asset-backed securities (ABS), or mortgages into mortgage-backed securities (MBS), is called securitization, the most important element of CRT. In the 1980s, the pooling of mortgages into collateralized mortgage obligations (CMO) became popular, giving investors the possibility to buy securities of different risk and maturity tranches (Poole 2008, p. 7) from a special purpose vehicle (SPV), which holds the mortgage pool as trust collateral in its balance sheet. The SPV is working independently from the loan originating bank, so the ABS or CMO buyers have on the one hand no claim on the other assets of the bank, on the other hand a worsening of the banks condition would not affect them, as pictured in figure 4 (Kaplan 2014, pp. 250f.). Since the credit risk is carried by the buyer of any of these instruments, he can be regarded as the effective lender of the loan (Davi 2009). The mentioned pooling of individual loans into collateralized products is justified, because for some types of single assets, e.g. leases, exists no secondary market (Jobst 2008).

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Figure 4: How securitization works, source: Jobst 2008

Another popular form of CRT is the usage of credit default swaps (CDS) which were invented in the 1990s (Unit 1 2016, p. 16). With the help of these instruments, banks can buy credit protection for their outstanding loans by paying the CDS seller a negotiated upfront or periodic premium. In case of a defined trigger, e.g. the default of the underlying instrument, the seller has to pay the change in value to the buyer (Koch/MacDonald 2015, pp. 573f.). In practice, CDS are available for larger amounts of corporate debt, e.g. for bonds. So there will be no CDS which perfectly hedges the banks credit portfolio (Pausch/Welzel 2012, p.19), commonly containing of small and unique mortgages. In contrast, there exist types of CDS which depend on the previously described MBS (Davi 2009) which could in turn help transfer credit risk to the market, even if it’s not related to the individual loan.

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Figure 5: Credit default swaps, source: Marketcalls 2011.

Concerning the credit access of borrowers, the first argument is, that active secondary loan markets give banks with limited possibilities of lending, e.g. because of the Basel capital requirements, the chance to originate a lot more loans. These are then distributed to other market participants, who have a surplus ability of lending and no possibility of originating loans themselves (Demsetz 2016, p. 31). That should basically lead to a better market access for local borrowers with riskier characteristics, whose loan requests would otherwise be rejected. This process could also be described as an efficient transfer of resources between banks of different locations worldwide with varying maturities of housing stocks and credit demand (Crane/Bodie 1996). There exists evidence that banks who use CRT by issuing ABS maximize their target loan levels to 150% (Goderis et al. 2007, p.26) while maintaining a significantly lower ratio of capital to risky assets compared to their non-CRT peers (Duffie 2007, p.1), supporting the view of efficient capital usage.

Another positive aspect of CRT is the increased diversification of assets through a wider range of investible products (Jobst 2008). This is possible for both the originating as well as the buying institute by constructing a portfolio of preferably uncorrelated loans of different banks, regions and customer types. It leads to lower risks for both transaction sides respectively the whole banking system, even if the total accumulated risk stays the same (Duffie 2007, p.1). If we conclude a better system stability, the probability of bank defaults and contagions should be lower, what indirectly could be regarded as a state of better credit access than without CRT, because in a collapsing system the willingness of banks to expand their lending tends to zero. It has to be noted, that the diversification benefit is not recognized in the mentioned Basel framework (Zaher 2007). So if we assume that every bank in the system has exhausted its maximum possible risk-weighted asset budget, there could be no additional lending only through diversification, even if the effective individual portfolio risk is lower as described. That is solved practically through risk dispersing out of the banking system to institutional investors who are not subject to the Basel regulation. ‘If securitized debt is traded, investors can quickly adjust their individual exposure to credit-sensitive assets in response to changes in personal risk sensitivity, market sentiment, and consumption preferences at low transaction cost’ (Jobst 2008).

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