UK: Get the Basics Right, Advises FSA- Securities and Banking Update May 2005

Last Updated: 2 June 2005
Article by Mike Williams

The FSA’s focus on outstanding confirmations and the involvement of senior management in risk management in the credit derivatives market is more than just scratching the surface of a substantial challenge. It’s a good example of a regulator modifying wider behaviour by targeting the straightforward issues first. The Joint Forum’s recommendations will provide a more wideranging test for the industry.

An uneducated reader of the FSA’s February 2005 letter to Chief Executive Officers, in respect of the risks inherent in the credit derivatives market, might be forgiven for thinking that the FSA had become fixated on cleaning the "pipework", or the operational processes which support these complex derivative transactions, while ignoring the real market risks which underlie them. Nothing could be further from the truth.

The growth of the credit derivatives market is truly phenomenal. As was recently quoted, the British Bankers Association estimate that the value of the market increased worldwide from $180m in 1997 to almost $2bn in 2001, and to more than $5bn in 2004. They predict that it will grow to $8.2bn by 2006. The rapid increase in credit derivatives has not escaped the regulators’ attention, for a variety of reasons.

There are concerns at a macro level that the entities engaged in this market place do not fully understand the risks associated with these transactions and may not be achieving the risk transfer they anticipate; that the use of credit derivatives might be creating "hidden concentrations" of credit risk; and that there might be a financial stability impact from the changes wrought by credit derivatives to the way, for example, the linkages (and hence risk of contagion) work between the equity and bond markets. At a micro level, there have been concerns that trading firms may be dealing in insurance products, for which they are not authorised, or may by virtue of their trading strategies be creating an operational risk nightmare of individual trades to manage.

These issues are considered in the Joint Forum’s report on Credit Risk Transfer, which was published in final form on 18 March 2005. The Joint Forum brings together the resources of the Basel Committee on Banking Supervision, the International Organization of Securities Commissions, and the International Association of Insurance Supervisors, under the Chairmanship of Gay Huey Evans, who also wrote the "Dear CEO" letter from the FSA, in her role as Director of the Markets Division.

The two issues which the FSA pick up on in their letter to CEOs, namely the operational risk arising from outstanding confirmations and the effectiveness of communication with calculation and paying agents, form a subset of the much wider ranging recommendations included in the Joint Forum report, but an important one.

The FSA’s letter starts by emphasising the importance of sound risk management for all firms at a principles level. The involvement of senior management in trading and risk management policies and procedures for credit risk transfer instruments is also the first recommendation of the Joint Forum report. There is a plain message for senior management here – you are responsible for demonstrating your control of these transactions, from the trading strategies you undertake, to the credit models you use to evaluate the risks of that trading, to the settlement and confirmation processes for those trades. Evidence of failure in one aspect of controlling this business may well indicate a much wider issue with your management of it.

The issue of outstanding confirmations, while a seemingly less significant one, is telling in terms of FSA’s perception of firms’ attitudes to operational risk. Clearly, there has been some good progress in the recent past arising from ISDA’s initiative on outstanding confirmations in OTC derivatives, but nonetheless firms have tolerated in the past that significant backlogs of outstanding confirmations have built up on some of the riskiest transactions in their books. Given the attention often paid to the legal documentation supporting these transactions, this either demonstrates an incomplete understanding of the settlement risk arising from these transactions or back office systems and staff struggling with the complexity and/or the volume of trades.

Hence, the level of outstanding confirmations often being one of the FSA’s first points of enquiry when a firm initiates a CAD I or VAR model application. It is entirely correct that the FSA should examine firm’s ability to demonstrate strong controls around these trades, particularly as they offer potential reductions in the counterparty risk charges for OTC transactions based on the fact that there is a greater level of legal and documentary due diligence associated with those transactions. No doubt the discussion of risks arising from outstanding confirmations is also a good lead in to accustoming firms to the maintenance of operational risk databases and the recording of operational risk exceptions as an important element of regulatory capital setting post the implementation of Basel II in 2007/8.

The issue of communications with agents again speaks to a key operational risk, namely that the communication of rate fixing information for the calculation of interest and principal payments is undertaken on a timely and effective basis by the calculations agent so that paying agents and issuers may be notified in good time of rate or index determinations. Custodians and investors may then in turn be notified on a timely basis of impending cash movements.

The FSA’s letter is a good example of the regulator attempting to modify firms’ behaviour by targeting the straightforward areas of improvement first. The Joint Forum recommendations are much more wide ranging, targeting firms’ behaviour at all levels, including the following areas:

  • Better understanding of the credit risk associated with the valuation model’s limitations and underlying assumptions, of the effect of changes in correlation assumptions on the model results (particularly where firms are actively trading correlation), and of the risks that cannot be easily captured in firms’ risk management systems (eg. issuerspecific risk);
  • Capturing the aggregate risk to an individual counterparty, where there may be direct exposures with that counterparty but also indirect credit risk transfer transactions creating exposures;
  • Improving the management of credit risk on unfunded credit risk transfer exposures, by the use of legally enforceable netting agreements, regular comparison of credit exposures to limits, etc;
  • Further efforts to reduce legal risk by standardising the documentation supporting credit derivative transactions and giving clearer disclosure to counterparties of firms’ roles and responsibilities in particular transactions;
  • Better understanding of the nature and scope of external ratings applied to credit risk transfer instruments, how ratings differ for these types of instruments and how rating methodologies vary between the rating agencies;
  • More dynamic review of key decision or trigger points in respect of individual structured transactions (eg. the ability/right to substitute reference credits);
  • Better understanding of the liquidity of individual credit derivative transactions and their hedges in risk managing the business; and
  • Separate disclosure of the profile of credit risk transfer instrument exposures (eg. by credit quality, industry or geography), more discussion of the purpose and nature of trades undertaken in publicly available material like the financial statements, and separate disclosure of trading risk exposure and revenue arising from credit-related risks (eg. disclose credit-related VaR separately).

The quid pro quo from the regulators themselves is greater efforts to understand the evolution of the market place, share information on credit risk transfer transactions and regulatory approaches to capital requirements for such transactions, and to regularly review supervisory guidance and reporting mechanisms for these instruments. The recommendations are timely given the growing size and maturity of the market place and, like the "Outsourcing Guidance for Financial Services" also issued by the Joint Forum in February 2005, they provide clear high level guidance for firms to follow.

As is now familiar, the FSA’s influence is now being felt as much as by its involvement at European level than in its local rule setting. The report, and the function of the Joint Forum, also reflect the growing overlap between the banks, investment banks and insurance firms in the transactions they undertake and necessarily therefore the way in which they are regulated. Not so much cleaning the pipework as preparing the way for Basel II and the Capital Requirements Directive (which will detail minimum capital requirements for credit derivatives) and beyond.  

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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