Banks Find a Way to Spread Their Risk
By VINCENT BOLAND
02/17/2003
Financial Times - FT.com
The most-asked question of this bear market is why there has not been a banking crisis. It is a pertinent question when one considers that the creditworthiness of the corporate sector is at its weakest for a decade.
More companies defaulted on more debt in 2002 than at any time previously. According to Standard & Poor's, 234 companies defaulted on a combined $178bn of obligations.
That is more than four times the default rate of 2000.
Yet the casualties of this rate of default are not to be found among the world's banks. The financial sector is not immune to the impact of the collapse in share prices and the steep decline in credit quality. The insurance sector in Europe has been especially badly hit, and individual banks such as JP Morgan Chase have been hit by exposure to risks, such as that of the collapsed energy trader Enron.
But the banking sector has so far emerged relatively unscathed compared with crises past.
"Financial institutions have become much more sophisticated at analysing their risk portfolios than they used to be; they have learnt the lessons of previous crises," says Robert Pickel, chief executive of the International Swaps and Derivatives Association.
Those lessons - from the Latin America debt crisis and the collapse of the savings and loan industry, among others - identified credit risk as the banking sector's Achilles' heel. A bank that, say, lends money to a company is exposed to the risks that interest rates rise or fall, that the company might default, that bond or loan prices rise or fall, and that there might not be a buyer for every seller. Together, these factors comprise credit risk.
So it is hardly surprising that from the late 1980s banks on both sides of the Atlantic put some of their best brains to work on ways to better manage credit risk. The result was the rapid growth of the credit derivatives market, where risk is spread more widely through the banking and financial sectors, and often outside them, to hedge funds and fund managers.
"Credit derivatives shift risk around; they don't increase or reduce it," says Stephen Figlewski, professor of finance at the Stern School of Business at New York University and editor of the Journal of Derivatives. "For the most part, what that means is risk is being better managed."
Credit derivatives work, their proponents say, because they transform the underlying security. For example, packages of corporate bonds can be grouped together and broken into their constituent risk elements through securitisation or structured products such as collateralised debt and loan obligations. These new types of securities are then sold to an expanding group of investors, including insurance companies, hedge funds and, increasingly, portfolio investors.
Estimates of the size of the credit derivatives market today show the extent to which credit risk management is now a priority for the banking sector. According to the British Bankers' Association, the global credit derivatives market was worth $1,189bn in 2001, potentially expanding to $1,952bn in 2002 and $4,800bn in 2004.
This growth results from the greater use of the capital markets by companies to raise money, and the fact that banks simply lend less to companies individually than they used to.
At the same time, "credit events" - events in the corporate or geopolitical spheres that influence the credit markets - have risen sharply. The three most spectacular since the bear market started were the collapses of Enron and Swissair, and the biggest ever sovereign default, by Argentina.
Individually, Enron's collapse hurt JP Morgan Chase severely; that of Swissair hit the Swiss banks hardest. But Argentina's default had a limited impact because many banks had either written off their lending or pulled out of the country altogether.
Much of the remaining exposure was held by hedge funds and "vulture funds", hedged through the credit derivatives market. So the crisis, while devastating for the people of Argentina, caused barely a ripple in global financial markets.
The expansion of both corporate bond and structured finance markets has lured many new participants to the credit markets. Given the explosive growth in the use of credit derivatives accompanying this expansion, regulators have expressed concern that many participants in the market, especially among investors, did not understand fully the types of complicated products - essentially a form of insurance - they were buying.
That may be the case but the most spectacular user of credit derivatives to go into crisis was Long Term Capital Management, supposedly one of the most sophisticated investors around. It had to be saved from collapse by Wall Street banks at the instigation of the Federal Reserve after its bets on credit markets went wrong. European insurance companies, which invested heavily in the US credit markets in the 1990s, are now suffering from the deterioration in credit quality that has accompanied the bursting of the stock market bubble.
Yet, bankers argue, credit risk is not the concentrated problem it used to be. Blythe Masters, head of global credit portfolio management at JP Morgan Chase, says: "Ultimately, what the credit derivatives market provides is the ability to hedge credit exposure with far greater liquidity than is available in the corporate bond or credit markets."
She adds that since there has not been a banking crisis, the credit derivatives market is being shown to be doing its job. Still, regulators continue to fret about the market's effectiveness in spreading risk more widely. In January, the Bank for International Settlements expressed concern that the market was too concentrated among a small number of participants and disclosure levels were not satisfactory.
It also highlighted the danger of believing risk can be eliminated. "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 bank said. Only then, perhaps, will we know for sure whether the banking sector has learnt all the right lessons.