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Market dynamics associated with credit ratings: a literature review

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Over the past few years there has been rapid growth in credit risk transfer instruments, including credit derivatives, and increasing use of these instruments by a diverse range of market participants: banks, insurance and reinsurance companies, mutual funds, as well as companies and hedge funds. This has led the authorities that participate in the Financial Stability Forum to examine this issue and the possible repercussions of recent developments. In this respect, there are two conflicting views: some people consider that the greater dispersion of credit risk across a wider spectrum of agents may contribute to the stability of financial systems; for others, however, the spreading of credit risk may give rise to new sources of instability if the new holders of this risk are unable to accurately assess and manage it. In order to increase their knowledge of these products, in the second half of 2003 the French supervisory authorities – the Commission de Contrôle des assurances (Insurance Supervisory Commission), the Commission des Opérations de Bourse (Stock Exchange Commission), and the Commission Bancaire (Banking Commission) – conducted a survey of credit institutions, insurance and reinsurance companies, and asset management companies. The survey’s findings, which constitute the first joint assessment of credit risk transfers undertaken by the French authorities, are presented in this article. These findings, which only relate to agents in the financial sector, are not a cause for particular concern from the point of view of financial stability. Indeed, the vast majority of risk transfers take place between major banks, especially in the case of credit derivatives, and mainly involve large US banks. This concentration of players is not specific to credit derivatives — it is reproduced with respect to derivatives across the board. However, the situation is more diverse where structured products are concerned. Here the involvement of insurance and reinsurance companies and mutual funds is more significant, although the bulk of transactions take place on highly-rated instruments. In terms of the transactions themselves, the results of the survey highlight the importance of new types of risk associated with these instruments: legal and documentation risk, and also illiquidity risk for non-standardised products. Given that the use of these products is likely to expand, market participants need to be well aware of the risks associated with them and endeavour to improve their assessment and management of these risks. Moreover, greater progress in terms of financial transparency is desirable in this area. All in all, this should help to make this market more mature, more liquid and therefore less risky.

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  • ., 2004. "Market dynamics associated with credit ratings: a literature review," Financial Stability Review, Banque de France, issue 4, pages 77-93, June.
  • Handle: RePEc:bfr:fisrev:2004:4:2
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