Credit Derivatives and Structured Credit: A Guide for Investors

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Credit Risk and the Emergence of Credit Derivatives

Walter Wriston, the former Chief Executive Officer of the American bank Citibank, held that ‘bankers are in the business of managing risk, pure and simple, that is the business of banking.’¹ Banks are distinct from other enterprises in that they seek risk,² which is the source of their profits and the basis of their business. However, these risks, deliberately taken, must be managed. In this respect, the 1990s emerged as a key period in financial practice, characterized by:

• Deregulation and growing internationalization of banking and financial activities.
• Considerable advances in information and communication technologies.
• Important conceptual advances resulting in better risk modeling (e.g. the value-at-risk concept for market risks).
• The phenomenal growth in derivatives (on organized and over-the-counter markets), now clearly the preferred instruments for managing financial risk.
• The widespread wish to optimize capital management,³ the very essence of economic warfare, especially in the banking industry.

In this context, an examination of why credit derivatives have emerged is tantamount to considering credit risk as the main risk run by banking institutions. Indeed, it was the ever-more urgent necessity to manage credit risk that led to the development of the first credit derivatives, not least insofar as the traditional methods for managing credit risk were found to be unsatisfactory and sometimes ineffective.

In this ...