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The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions

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  • Li L Ong
  • Jorge A Chan-Lau

Abstract

The increasing ability to trade credit risk in financial markets has facilitated its dispersion across the financial and other sectors. However, specific risks attached to credit risk transfer (CRT) instruments in a market with still-limited liquidity means that its rapid expansion may actually pose problems for financial sector stability in the event of a major negative shock to credit markets. This paper attempts to quantify the exposure of major U.K. financial groups to credit derivatives, by applying a vector autoregression (VAR) model to publicly available market prices. Our results indicate that use of credit derivatives does not pose a substantial threat to financial sector stability in the United Kingdom. Exposures across major financial institutions appear sufficiently diversified to limit the impact of any shock to the market, while major insurance companies are largely exposed to the "safer" senior tranches.

Suggested Citation

  • Li L Ong & Jorge A Chan-Lau, 2006. "The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions," IMF Working Papers 06/139, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:06/139
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    References listed on IDEAS

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    1. Marco Stringa & Allan Monks, 2007. "Inter-industry contagion between UK life insurers and UK banks: an event study," Bank of England working papers 325, Bank of England.
    2. Hasbrouck, Joel, 1991. " Measuring the Information Content of Stock Trades," Journal of Finance, American Finance Association, vol. 46(1), pages 179-207, March.
    3. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series 2004-36, Board of Governors of the Federal Reserve System (US).
    4. Marsh, Ian W & Wagner, Wolf, 2004. "Credit Risk Transfer and Financial Sector Performance," CEPR Discussion Papers 4265, C.E.P.R. Discussion Papers.
    5. Ingo Fender & John Kiff, 2004. "CDO rating methodology: Some thoughts on model risk and its implications," BIS Working Papers 163, Bank for International Settlements.
    6. Cousseran, O. & Rahmouni, I., 2005. "The CDO market Functioning and implications in terms of financial stability," Financial Stability Review, Banque de France, issue 6, pages 43-62, June.
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    Cited by:

    1. Calice, Giovanni & Ioannidis, Christos, 2012. "An empirical analysis of the impact of the credit default swap index market on large complex financial institutions," International Review of Financial Analysis, Elsevier, vol. 25(C), pages 117-130.
    2. Mork├Âtter, Stefan & Westerfeld, Simone, 2009. "Rating model arbitrage in CDO markets: An empirical analysis," International Review of Financial Analysis, Elsevier, vol. 18(1-2), pages 21-33, March.

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