Credit Securitisations and Derivatives: Challenges for the Global Markets

Foreword

Thilo Liebig

Deutsche Bundesbank1

Credit risk is at the core of commercial banking. In recent years, we have seen the rampant emergence of new techniques for credit risk management, especially securitization and credit derivatives such as credit default swaps (CDS). Both instruments have in common that they allow banks to separate credit origination from credit risk. From an economic point of view, this separation is reasonable: banks can extend their lending and are no longer constrained by their risk-taking capacity. By securitizing the loans and buying or selling credit protection, banks make the credit risk tradable and shift the credit risk out of their balance sheets to other market participants who are better able to bear this risk or wish to diversify their portfolio.

From the standpoint of financial stability, however, during the financial crisis, securitization and credit derivatives sometimes failed to meet the high expectations placed on them. Separating credit origination from the credit risk occasionally gave the wrong incentives. Since they were able to dispense with the risk, banks no longer had a strong incentive to carefully select and monitor the borrowers. As a result, credit standards began to deteriorate; loans to the sub-prime sector grew to a high level. Moreover, the banks' additional lending capacity increased the mortgage supply in the US, thereby amplifying a bubble in the US housing market. Incentive problems of a different kind are said to ...