About | HeinOnline Law Journal Library | HeinOnline Law Journal Library | HeinOnline

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

What Is HeinOnline?

HeinOnline is a subscription-based resource containing thousands of academic and legal journals from inception; complete coverage of government documents such as U.S. Statutes at Large, U.S. Code, Federal Register, Code of Federal Regulations, U.S. Reports, and much more. Documents are image-based, fully searchable PDFs with the authority of print combined with the accessibility of a user-friendly and powerful database. For more information, request a quote or trial for your organization below.



Short-term subscription options include 24 hours, 48 hours, or 1 week to HeinOnline.

Contact us for annual subscription options:

Already a HeinOnline Subscriber?

profiles profiles most