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ISDA PRESS REPORT - NOVEMBER 12, 2001 CREDIT DERIVATIVES * ISDA survey reveals strong upward trend - IFR * ISDA's new supplement includes converts in default swaps - Dow Jones RISK MANAGEMENT * The Basle perplex - The Economist * Supervisors review cross-sectoral practice - IFR ISDA survey reveals strong upward trend IFR - November 10, 2001 The global notional outstanding volume of credit derivatives transactions hit US$631.497bn for the first half of 2001, according to the International Swaps and Derivatives Association's first survey of credit derivatives transactions. "While still modest in relation to interest rate products, this figure is expected to remain on a strong upward trend compared to more mature derivative product areas," ISDA said. ISDA surveyed total notional outstanding volumes for single name credit default swaps, default swaps on baskets of up to 10 credits, and portfolio transactions of 10 credits and more. Eighty-three member firms supplied data for the survey. Interest rate and currency derivatives growth clocked in at just above 3.5% in the first half of the year among members that also reported at year-end 2000, ISDA said. For these firms, total notional outstanding volumes increased to about US$55.2trn from roughly US$53.3trn. Total notional principal of interest rate swaps, interest rate options and currency swaps for all surveyed firms slid to US$57.3trn from US$G3trn at year-end last year. Among the top 10 dealers, a minor decrease in volume from US$35.6trn to US$35.Strn was recorded, ISDA noted. According to Thomas Montag, chair of ISDA's market survey committee, the shifting product use reflected greater uncertainty in the global market environment. "The market for credit protection has an obvious appeal during times of economic downturn," he added. ISDA's survey is compiled twice a year by Andersen. Sixty-seven of the 83 member firms that participated in this survey also participated in the previous survey. ISDA's new supplement includes converts in default swaps Dow Jones - November 12, 2001 By Joe Niedzielski NEW YORK -(Dow Jones)- The International Swaps and Derivatives Association has published a supplement to its 1999 document for credit derivatives which incorporates convertible bonds and zero-coupon bonds, among others, as deliverable securities in these contracts. The trade group said late Friday that it had finalized and published its Supplement Relating to Convertible, Exchangeable or Accreting Obligations. The supplement addresses the treatment under the 1999 ISDA Credit Derivatives Definition of certain types of convertible and exchangeable obligations, as well as the treatment of accreting obligations, such as zero-coupon bonds, low coupon bonds issued at a discount and non-discounted bonds that accrete during their term, ISDA said. "The Convertibles Supplement represents the consensus of a diverse range of constituents in the credit derivatives markets, including portfolio managers, credit protection sellers and dealers," said Robert G. Pickel, ISDA's executive director and CEO. Credit default swaps allow buyers to transfer the risk of a default on obligations like bonds or loans, or other types of credit events like a debt restructuring. They have had a growing influence in the broader fixed-income universe, at times playing a role in the pricing of corporate bonds. And some convertible-bond investors will lay off the credit risk from the fixed-income portion of a convertible security by buying credit default swap protection. ISDA's supplement was expected. A group of U.S.-based dealers submitted a proposal to ISDA a few months ago to include obligations like convertible bonds as deliverable securities in these contracts. And in mid-October, ISDA told members that convertible bonds were deliverable under standard credit derivatives contracts. The group's memorandum to members came in response to questions from members following the appointment of a railway administrator for Railtrack PLC (U.RTK). Holders of convertible bonds issued by Railtrack had complained that some sellers of credit protection weren't paying claims on default swap contracts on the Railtrack credit. The Basel perplex The Economist - November 8, 2001 The arcane world of banking supervision is not usually the talk of German chancellors on tours of Asia. Gerhard Schr?der made an exception recently when he threatened that Germany would veto any new European directive based on the latest proposals from the Basel committee of big-country bank supervisors. In its present form, said Mr Schr?der in Bangalore, Basel 2 (as the proposals are known) is "unacceptable to Germany". Basel 2 attempts to formulate more precisely than before the levels of "regulatory" capital that banks must hold as a cushion against the credit and other risks that they run. After more than three years of talks, the Basel boffins have developed rules which are still not acceptable to commercial banks. That is strange, since they are supposed to mirror the way the world's most sophisticated banks themselves calculate their risks. The whole exercise has shades of Heath Robinson about it. The banks are up in arms, this week bearding the Basel committee for its latest draft rules, which get ever more complicated and prescriptive. By the time they are implemented, in 2005 at the earliest, the rules look likely to burden banks with extra costs (ie, through the need to run parallel reporting systems) and perverse incentives to "game" the system. Basel 2 could thus aggravate the very thing it set out to correct, a distortion of financial markets. Germany's grouse has to do with the Mittelstand, the 3m small and medium-sized companies that are the economy's backbone. The Basel 2 formulae for credit risk are based on credit ratings applied to company debt, either by rating agencies or internally by banks themselves. But few smaller companies are rated in this way. Moreover, German companies are more than usually dependent on medium-term bank loans, and the longer the loan the more it is penalised under the proposals. The Germans-but also the Italians and the Japanese-fear that their medium-sized companies will lose under the new capital regime. Many of the 2,800 German banks are not equipped to rate the companies to which they lend: equipping them would drive up the cost of lending. German bank associations plan to help by pooling credit data for their members. But Mr Schr?der's advice to banks last week was that they should not be overhasty in applying the new Basel principles ahead of time. Already the committee is working on a fix. On November 5th it posted a clutch of new suggestions on its website that included new risk weightings for smaller companies, and proposals that physical collateral, receivables and even leased assets be used to lessen a particular company's credit charge. These were interim ideas, it said, which needed to be tested and even revised. All well and good. But the Basel committee is getting into knots trying to address every objection as it arises. Each time, it seems, the committee adds another layer of complexity for banks and their supervisors to master. Most recently, after strident objections by banks, there was the shifting of the "w-factor" (the possibly unquantifiable residual risk in a credit derivative) from one supervisory category to another, and also the setting of arbitrary minimum risk weights for unrated securitised assets. The figure for operational risk (non-market risks such as the loss of data, a rogue trader or the destruction of a bank's headquarters) has been slashed, after objections from banks. The November 5th pabulum came in response to a "quantitative impact study" (a live study of how the proposed capital charges would affect a sample of 138 banks in 25 countries). The Basel committee has always said that the scale of charges needs to be properly calibrated. In fact, it gave itself an extra year to get the calibration right. It has invited some banks to take part in a fresh impact study using its latest proposed adjustments. The results should help the Basel committee to tweak its formulae to get results. Its declared goal is not to increase or decrease the overall capital charge imposed on the banking system, merely to allocate it more efficiently. But some regulators are worried that the more risk-sensitive the regime is, the more reluctant banks will be to lend in a downturn, aggravating economic cycles. There are attempts to fix this too. For example, Spain allows its banks to make a provision at the inception of a loan-putting money aside for a rainy day. Some countries need to fix their accounting regimes before they can follow suit. Regulators appear stoically optimistic that all these fixes will work, and that a credible new framework will be established-not without flaws, perhaps, but better than what exists today. The timetable may slip, but the plan is to produce a final draft framework early next year, allowing consultation until the end of March, which should result in a firm set of rules by the end of 2002. That, in theory, still allows time for the European Union to draft and finalise a matching directive on capital adequacy for banks and financial firms, to be in force by January 2005. With Basel 2, bank supervisors are trying to do three main things. They want to devise formulae that bring capital charges closer to the banks' own measures of risk. They want to establish continuous review of banks' management, and especially of their risk management, as a factor in adjusting the capital charge. And they want to create incentives for greater public disclosure of banks' risk exposures. This is an attempt to let markets take on more of a supervisory role. Yet, in reality, the supervisors are becoming micro-managers. A member of the Basel committee insists that most of the world's 36,000 banks will be governed by a regime no more complex than Basel 1, in force today. The more sophisticated financial groups that aspire to a so-called "advanced" approach will be treated differently. "We'll be crawling all over them initially," says the supervisor, "because ultimately we're giving them more freedom." All the same, in between the lowest and the highest, thousands of banks will be graduating from a standardised to a more sophisticated approach, with heavy demands on supervisors' time. Only America and Britain already have a culture of continuous review by supervisors. Most other regimes are either less sophisticated, or they are hamstrung by non-adjustable capital charges that are set at a minimum by law. Then there is the Brussels hurdle. Whatever the Basel committee decides works for banks must be applied in the European Union to all investment firms, including broker-dealers and asset managers. The scope is huge for further descent into mind-boggling detail. Supervisors and financial firms may well end up thanking Mr Schr?der if he vetoed the lot. Supervisors review cross-sectoral practice IFR - November 10, 2001 The Basle Committee on Banking Supervision, the International Organisation of Securities Commissions and the International Association of Insurance Supervisors last week released, under the banner of the Joint Forum, two reports comparing risk management practices and principles in the sectors they supervise. Both reports were principally aimed at the supervision of conglomerates that incorporate businesses in banking, securities and insurance, but one also took a close look at risk transfer practices. The first report, Risk Management Practices and Regulatory Capital, compared the approaches in each sector in an effort to "gain a better understanding of current industry practices in all three sectors". The main sections of the report focus on: differences in core business activities, similarities and differences in risk management tools, approaches to capital regulation in the three sectors and cross-sectoral risk transfers and investments. It is in relation to the latter two sections that the report provided what some may regard as its sting. The Joint Forum suggested that as supervisors evaluate the extent of cross-sectoral activity, in terms of risk transfer using derivatives, securitisation and other techniques: "It may become important for the individual sectoral frameworks to be updated to better reflect the contemporary risk profiles of the firms subject to those frameworks. It would not be surprising, for example, for some jurisdictions in the near future to consider greater convergence in the frameworks applied to the different sectors." The report explained that supervisors should consider the potential for existing capital regulations to provide incentives for capital arbitrage. "To the extent that some firms are engaging in activities that are not addressed through capital requirements, supervisors need to ensure that other measures are in place to ensure that the associated risks are being appropriately managed and are supported by sufficient economic capital," it added. As a result, the report said, supervisors should continue to evaluate approaches that could be taken to address crosssectoral investments within the various capital frameworks. The second report, Core Principles, compared the core principles each supervisor has issued to its respective sector as risk management guidelines. The Joint Forum found that each set of core principles provided an overview of the essential elements of the supervisory regime in that sector at the time they were written (1997-2000). However, the pace of developments in the financial sector since then has required consideration of the need to keep the core principles updated. The report found no evidence of underlying conflict or contradiction between the three sets of core principles at the highest levels. However, in some cases there are significant differences in the application of similar principles. **End of ISDA Press Report for November 13, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.
ISDA PRESS REPORT - November 13, 2001