The increasing use of esoteric financial instruments known as credit derivatives poses a fresh challenge to banking and insurance regulation, the Bank of England warned yesterday.
Credit derivatives allow banks to offload credit risk to other financial institutions, usually insurance companies and investment funds. Banks use them to disperse exposure to potential bad debts relating to particular regional, sectoral or market shocks. Insurance companies see them as an additional source of premia revenue.
However, the Bank said in its latest half-yearly Financial Stability Review that credit derivatives may only serve to shift concentrations of risk from one place to another. It also voiced concern over the general traceability of credit risk.
David Rule, of the Bank's financial surveillance unit, said: "Concentrations of risk might decline in some places only to re-emerge in others. Unfunded risk transfer is, for example, more difficult to monitor from the available published statistics, potentially making any new concentrations less transparent." He highlighted insurance companies on the Continent and in Japan as among those that had taken on more credit risk in recent years.
But the Bank moved to dampen any alarm over the comments. "All we are saying is that people need to know where credit derivatives are going. This is something we need to understand more about," said a spokesman.
Mr Rule also noted that the banking system's ability to offload risk was limited by its traditional role in helping insurance companies settling claims promptly at a time of stressed market conditions. With the banking system a provider of committed credit lines, it would remain the financial system's final source of liquidity.
The prevalence of credit derivatives was underscored by the recent collapse of Enron, the US energy giant. A number of the bluechip banks feared to have been vulnerable to bad debts at Enron were found to have dispersed their exposure into the insurance and investment funds sectors. According to Standard & Poor's, the credit rating agency, $3bn (£2.1bn) was offloaded via credit derivatives, although some analysts put the figure much higher.Reuse content