CDOs and Financial Regulations

The collapse of the CDO market was basically caused by the liability structure of resecuritization. In light of this, in February 2009, the Basel Committee on Banking Supervision at the Bank for International Settlements (BIS) decided to place a higher risk weight on these resecuritized products.⁷

However, resecuritization is only one of the reasons that triggered the 2007–08 financial crisis. The mechanism in which the collapse of one market spread rapidly to other markets and brought about a large-scale dislocation of financial markets, eventually leading to a systemic risk, should be discussed. Once the sources of systemic risk are identified, I have to create institutional mechanisms that enhance safety.

The US Treasury Department released its report on “Financial Regulatory Reform–A New Foundation: Rebuilding Financial Supervision and Regulation” in June 2009.⁸ In its report, among others, they proposed strengthening the supervision and regulation of securitization markets through the following measures: (1) Federal banking agencies should promulgate regulations that require originators or sponsors to retain an economic interest in a material portion of the credit risk of securitized credit exposures. (2) Regulators should promulgate additional regulations to align the compensation of market participants with longer term performance of the underlying loans. (3) The Securities and Exchange Commission (SEC) should continue its efforts to increase the transparency and standardization of securitization markets and be given clear authority to require robust reporting by issuers of ABS. (4) The SEC should continue its efforts to strengthen the regulation of credit rating agencies, including through measures to promote robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise strengthen the integrity of the ratings process. (5) Regulators should reduce their use of credit ratings in regulations and supervisory practices, wherever possible. Although the details of the above proposals are not available, item (3) appears to be most relevant to our discussion.

4.1 Possibility of Product Regulation

Since the 1980s, financial innovations have been rapidly adopted and financial deregulation in the Organisation for Economic Co-operation and Development member countries, led by the US, has been advanced. In most cases, the implicit presumption was that these innovations improve welfare, with negligible downside risk exposure. The prolonged period of what was dubbed the “Great Moderation” further alleviated concerns about the downside risk associated with financial intermediation. This trend was particularly evident in the last several years until 2007, as is reflected in the remarkable decline in the market price of risk.

The moderation also reduced the demand for regulation.⁹ Concerns about the inherent principal-agent/moral hazard associated with financial intermediation were arguably eliminated, and thereby, the potential role of the regulator seemed to have been minimized in order to enhance the efficiency gains in major financial centers.

Under these circumstances, financial product regulations have been lifted in most advanced economies, especially for financial products that are specifically designed for institutional investors. It is rather common for the products sold to so-called qualified investors to be exempted from general product regulations. It seems that, in the past two years, even institutional investors were involved in serious problems related to complex financial products; therefore, some people argue that new regulations may be needed for such complex products. If this is the case, the purpose of the regulation must be different from the traditional rationale: in fact, product regulations are originally stipulated for the purpose of protecting individual investors.

In hindsight, regulating specific risky products by either placing a higher risk weight or placing them under a more direct regulation seems to be possible; however, in reality, it is not clear whether it is possible to regulate these products in advance because of their innovative nature.

Although the 2009 BIS annual report suggests the possibility of a registration and certification system of (newly introduced) financial products, the feasibility of such product regulation is highly doubtful. Past experiences of product regulation show that such regulation proved to be not only ineffective because of the circumventing activities of financial institutions, but also inefficient in that a significant amount of resources were used in checking and monitoring a variety of products.¹⁰ Simply reversing the policy stances of the past 20 years could backfire as I may overshoot the needed adjustment, creating other distortions.

The problem herewith is not confined to one particular type of financial product; it also concerns the problems arising from common exposure to a particular risk and high sensitivity to some changes in macrovariables such as interest rates and housing prices. Thus, in the next subsection, I will discuss the issue from the perspective of macroprudential regulations.

4.2 Securitized Products and Systemic Risk: Extensive Reporting Requirements

To address the nature of systemic risk, the aggregation of risk information is critical. CDOs are largely sold in private markets, and thus, detailed data is not publicly available. The undisclosed positions of the so-called toxic assets negatively affect the counterparty risk of financial institutions. In stressed situations, ambiguity with regard to the trading volume and relevant market information deteriorates liquidity. This fear was especially prevalent in over-the-counter (OTC) trades.

Against the background described above, an approach that financial regulators can adopt is to collect information about financial products, especially new and rapidly growing products, and release aggregate figures. Extensive required reporting of the marketable outstanding, size of issuance, and positions should be considered. It could contribute to being cautious about the potential economy-wide risk that concerns regulators. As has already been proposed by some authorities, reporting requirements of the positions of large institutions is also useful. The challenge lies in specifying the relevant measures of appropriate reporting items.

Aggregate data provides the basis of judgment on the soundness of a particular market. The Japanese Financial Service Agency (FSA) has been releasing data on the total number of holdings of subprime-related assets by Japanese banks since November 2007.¹¹ This must contribute to the elimination of an unfounded fear concerning Japanese banks associated with subprime-related losses. Although some of major US banks began disclosing the positions of toxic assets, it was still unclear as to what extent US banks altogether were exposed to these assets and whether the scale of capital were sufficient for these exposures.

In addition to the common exposure to particular risks and vulnerability to macroeconomic risks, the existence of complex and opaque instruments—for example, the various structured products, including securitized subprime mortgages that were difficult to value and sell—could create systemic risks, as has already been discussed.

First, the structured products present the obvious problem that evaluations of their riskiness are unlikely to be reliable. When the valuation is imprecise, it complicates not only risk management within individual institutions, but also the already difficult task of evaluating common exposures. A concentrated position or a series of counterparty relationships poses the systemic risk of joint failures if market participants and regulators fail to understand and accurately value these financial instruments.

The second systemic risk posed by such instruments is their capacity to exacerbate procyclicality. Typically, booms are characterized by financial innovations. When things are going well, firms and individuals feel confident to experiment. They create new, untested instruments that are difficult to understand and value. Investors tend to be highly optimistic about future economic conditions during the boom without seriously considering the possible risks when markets deteriorate; further, sellers have little incentive to convince them otherwise. The result is that during a boom, flourishing financial innovation tends to create hidden, underpriced risks. However, as strains develop and the boom begins to wane, the previously unseen risks materialize, deepening the retrenchment that is already underway. Although financial innovation is a source of progress, it could become a source of procyclicality and systemic risk as well.

While the second issue was difficult to address by financial regulations, the first issue arising from the opaqueness of valuation may be improved by regulations on rating agencies and voluntary actions on the part of industry. For example, the data on CDS transactions became more extensively available after November 2008 through the Depository Trust & Clearing Corporation (DTCC) system, which could reduce counterparty risk involved in these transactions.

4.3 Policy Implications for Asia

From the perspective of the benefits originally associated with securitization, it is important to develop the markets for securitization in emerging markets. With respect to securitization, I need to learn the following lessons from the 2007–08 financial crisis. First, underlying assets should have appropriate credit quality with sufficient historical records of defaults, their relationship to macroeconomic variables, and other relevant information. Second, complicated structures should be avoided since they lead to more opaqueness, vulnerability to macro shocks, and therefore, ambiguity in pricing. The original idea of securitization is simple: risk reduction through diversification. To the extent that large enough amounts of underlying assets are pooled, additional gain obtained from resecuritization must be limited.¹² Slicing into too many tranches is also problematic; it makes the exact pricing of each tranche more difficult and more vulnerable to a deterioration in the credit quality of the underlying assets.

To reap the benefits of securitization while minimizing risks, the Shadow Financial Regulatory Committee of Asia, Australia-New Zealand, Europe, Japan, Latin America, and the US proposed that the system implemented in Denmark, which is a “partially asset backed” model, be followed. In the securitization system implemented in Denmark, leverage is effectively limited by capital requirements since loans must remain on the banks' balance sheets. Covered bonds are similar types of securitization and are popular in Europe.¹³ These bonds are characterized by essential features that are achieved under special-law based frameworks or general-law based frameworks with regard to the issuers' status and obligations.

In order to promote the standardization and ensure the transparency in securitization in emerging markets, it may be necessary to discuss the issue at a practical level. In Europe, the Directive on Undertakings for Collective Investments in Transferable Securities (UCITS) plays an essential role. In Asia, in order to introduce a standardized securitization framework, I must have a mechanism to deepen the understanding of each market and discuss the future course of common factors in the basic legal framework for securitization.

With regard to the financial product regulations for retail investors, I can safeguard these investors from the risk posed by a complex structure of securitization by applying more general principles of financial regulations, such as suitability and disclosure. According to the BIS report (2008b), the suitability principle is well recognized in regulatory requirements; however, there are differences in its application by sector, and probably greater differences by country, which partly stem from the fact that not all supervisors have consumer protection mandates. If the authority wishes to avoid the problems arising from overly complex products, the basic principles such as disclosure and suitability must at least aim for protecting retail investors.

As discussed in the previous section, the financial debacles of 2007–08 were more closely associated with “sophisticated investors” and systemic risk. In this regard, the same prescriptions are applicable: timely disclosure of aggregated risk information should be prioritized.

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