Who’s Holding the Bag?

Everyone knows banks are shedding more risk these days. So where does it go?

June 10, 2005
Quarterly review: “Structured Finance: Complexity, Risk, and the Use of Ratings”

Issued by the Bank for International Settlements

Notes that the complexity of structured-finance products makes credit ratings less reliable, “even as their complexity creates incentives to rely more heavily on ratings.”

June 15, 2005
“Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, SPEs, and Transparency of Filings by Issuers”

Issued by the SEC

Although inspired by Enron-style complex structured transactions, the SEC’s off-balance-sheet report also focuses on more-mundane off-balance-sheet issues, such as leasing and pension-fund accounting. Its discussion of leasing, however, takes a swipe at the market’s response to Fin 46(R), warning that the use of securitizations and derivatives in accounting-motivated transactions may already be undermining FASB’s effort.

June 27, 2005
Annual report

Issued by the Bank for International Settlements

Warns that risks involved in structured-credit products may not be fully understood by all market participants. Reiterates that credit ratings may be misleading, adding that standard portfolio risk models may also be inadequate. Also warns that credit conditions fostering growth of CDS and CDO markets may not continue, and that it remains to be seen how these “markets would handle a string of credit blow-ups or a sharp turn in the credit cycle.”

July 18, 2005
“Hedge Funds: An Emerging Force in the Global Credit Markets”

Issued by Fitch Ratings

Warns that the impact of hedge funds on credit markets is poorly understood and that a forced deleveraging could be felt across multiple credit-market segments, reducing access to high-yield debt and structured-finance securities.

July 27, 2005
“Toward Greater Financial Stability: A Private Sector Perspective”

Issued by the Counterparty Risk Management Policy Group II

Issued by the same group that autopsied Long-Term Capital Management in 1999, this report suggests that operational risks pose the greatest current threat to the financial system. It also warns banks and others to make sure investors — including corporations — understand the derivatives they buy.

August 2005
“Don’t Bank on Strong Governance: Observations on Corporate Governance in U.S. Banks”

Issued by Moody’s

Notes that corporate governance is an increasingly important consideration in bank ratings. Among other conclusions, notes that Basel II’s requirement to identify and mitigate risk — including operational risk — is “becoming harder as the pace of innovation in financial instruments quickens.”

August 2005
“Systemic Risk and Hedge Funds”

Issued by Nicholas Chan et al., MIT

Concludes that “systemic risk is currently on the rise” for hedge funds and that their “symbiotic relationship with the banking sector” means that hedge-fund risk exposures “may have a material impact on the banking sector.”

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