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The effect of credit risk transfer on financial stability Elisabeth Joossens European Commission

The effect of credit risk transfer on financial stability Elisabeth Joossens European Commission Joint Research Centre of Ispra elisabeth.joossens@jrc.it Dirk Baur Trinity College Dublin INQUIRE Spring Conference Hamburg, 26-28 March 2006. Summary of the talk.

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The effect of credit risk transfer on financial stability Elisabeth Joossens European Commission

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  1. The effect of credit risk transfer on financial stability Elisabeth Joossens European Commission Joint Research Centre of Ispra elisabeth.joossens@jrc.it Dirk Baur Trinity College Dublin INQUIRE Spring Conference Hamburg, 26-28 March 2006

  2. Summary of the talk AIM: The paper shows under which conditions debt securitization of banks can increase the systemic risk in the banking sector • Literature • CDO’s and CDS • Risk transfer through securitization • Effect of increased linkages • Empirical analysis • Conclusions and outlook

  3. Literature • papers on systemic risk in banking sector and about debt securitization • differences with other financial products are studied by Bank of International Settlements and European Central Bank • credit risk transfer (BIS, 2005 and Bank of England, 2002) • reaction of bank’s beta on CDO issuance (Franke and Krahnen, 2005) • This paper : relation between securitizations and systemic risk

  4. CDO’s and CDS CDO : collateralized debt obligations • true-sale securitizations CDS : credit default swaps • synthetic or contractual risk transfer • a party (A) buys a security/insurance from another party (B) against losses of a certain asset

  5. Principal and Interest Loan/Bond Portfolio (Collateral) Senior Class AAA Asset Manager Trustee Issuer (SPV) Loan Assets Mezzanine Class(es) A/BB Cash Proceeds Cash Proceeds Equity (First loss Position retained The sponsor) Swap Counterparty Losses Collateral Debt Obligations (CDO) • CDO’s

  6. Collateral Debt Obligations (CDO) CDO : banks can transfer risk to other banks or to the market by debt securitizations (credit transfer) • a pool of assets is transferred to an SPV (Special Purpose Vehicle) • this SPV issues notes to investors with different risk appetite • original bank invest itself in most risky part (or first loss piece FLP) hence is convert for extreme losses

  7. Credit Default Swaps (CDS) CDS : offer insurance against loss but do not lower economic capital • Party A buys a security/insurance from B against loss of an asset • Buyer gives continuous payments in return • In case of default the seller pays the asset face value in return for the asset Counterparty A Counterparty B Bond + Fixed Payment Par value of Bond + Interest

  8. Risk transfer through securitization • Using CDO Using the constraint of equity piece A and senior pieces grouped in B the following inequality will hold Or extreme risk will not be reduced

  9. Risk transfer through securitization • Loss distribution using CDO’s applying Monte Carlo simulations total value = 100 equity piece = 30 7 years maturity LGD = 100% 99% quantiles

  10. Effect of risk transfer 2 cases of risk transfer: • sold to unregulated market participants (e.g. hedge funds) • banks invest in the same underlying pool (CDO) or cover each others risk (CDS) → increase interbank linkages

  11. Empirical analysis AIM: visualize impact of credit risk transfer on systemic risk in the financial sector MEASURES USED : credit risk transfer = CDO issuance in Europe systemic risk = coexceedances DEFINITION: COEXCEEDANCES Coexceedances are joint exceedances of asset returns above a given threshold

  12. Empirical analysis: the data CDO issuance • Quarterly data of European CDO issuance from ESF • From Jan 2000 till June 2005

  13. Empirical analysis: the data Monthly equity returns of 10 European banks and insurance companies

  14. Empirical analysis: the data Standardized monthly returns of European banks and insurance companies

  15. Empirical analysis: the data Coexceedances of monthly standardized bank and insurance company returns

  16. Econometric specification • Aim: analyze the effect of CRT on systemic risk • The model • Parameter of interest: β • Regression techniques • OLS • multinomial logit model • probit model

  17. Emiprical results • OLS from restricted version to extended version • βis never significant • problem: OLS does not account for categorical nature of dependent variable • Multinomial logit model to estimate the impact of exogenous variables on the categories • β > 0 but again not significant • coexceedances with more then 4 or 5 in one category • Unordered probit model (again more then 4 or 5 coexceedances all as one category) • β > 0 and significant • Logit model does not qualitative change results

  18. Conclusion and Outlook • How banks can reduce their capital requirements by transfering risk • Risks are transferred to other banks increasing the interlinkages and augment extreme risks • Empirical analysis shows that European CDO issuance is positively correlated with extreme movements  extreme risks increase • Check using larger period of time and more assets • Compare syntetic vs true sale CDOs • Relation systemic and systematic risk

  19. Correlation matrix

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