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9 J. Banking Reg. 1 (2007-2008)

handle is hein.journals/jlbkrg9 and id is 1 raw text is: www.palgrave-journals.com/jbr Editorial The deconstruction of financial risk Journal of Banking Regulation (2007) 9, 1-2. doi:10.1057/palgrave.jbr.2350060 George Walker reviews some of the principal background trends and changes that have taken place in modern financial markets and the challenges that these have created in terms offinancial stability and central bank function. All of the recent crises in US sub-prime lending, inter-bank markets, Northern Rock and most recent support operations announced by the Bank of England reflect certain more fundamental changes that have been taking place in national and international financial markets over the last two to three decades. A substantial amount of credit has moved from being bank to security based as part of a larger process of 'securitisation' in many markets. Banks specifically have been 'disin- termediated' in many cases with borrowers issuing their own debt through short-term commercial paper programmes or with securi- tised debt being sold into the market through special-purpose vehicles (SPVs) set up to support underlying securitisation programmes. A number of new types of financial instruments and vehicles have been created especially with SPVs and the separate growth in structured products including collateralised mortgage obligations (CMOs), collateralised loan obliga- tions (CLOs) and credit linked notes (CLNs) as well as other collateralised debt obligations (CDOs). Financial derivatives are now considered 'old' (having originated in the early 1970s) although derivatives and, in particular, credit derivatives are now often used for 'repackaging' purposes and frequently embedded into new financial instruments creating considerably more complex 'structured' products. There has also been a parallel process of 'privatisation' (in addition to disintermediation) of debt with the issuance and trading of debt through private placements, off-market 'introductions' or OTC markets rather than with full listing and formal public issues. This has, in particular, arisen as a result of the growth in the disposal or conversion of many public corporations into private companies and especially with the expansion of the private equity market which began in the 1970s but grew substantially during the late 1980s, 1990s and early 2000s. All of this (securitisation, disintermediation, financial innovation and repacking as well as privatisation of debt) has been associated with a further 'deconstruction' of risk within financial markets. This has involved exposures (includ- ing, in particular, credit risk) being broken up (or 'layered'), assigned a credit rating by a rating agency (often paid by the institution issuing the debt which practice is now being examined by the European Commission) and then sold off in separate security-based 'tranches'. The effect of this has been to distribute risk over a much wider category of investors (including hedge funds and other new investment vehicles such as SIVs and off-balance sheet bank conduits). Financial risk has then been divided up and distributed across the financial system in a much wider, less transparent and more complex manner than ever before. The original and direct management of risk by banks and other financial intermediaries has also been replaced by market rating and trading. Investors will often only purchase products with a view to selling them on to generate profit but also to avoid having to hold them to maturity and bear the loss for any outstanding or residual market or credit risk concerned. Original and © 2007 Palgrave Macmillan Ltd, 1745-6452 $30.00 Vol. 9, 1 1-2 Journal of Banking Regulation 1

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