The Bank of International Settlement (BIS) this week published an article called Structured Finance: Complexity, Risk and the Use of Ratings, highlighting some of the principal findings made by the working group established by the Committee on the Global Financial System (CGFS). The CGFS, which monitors the financial markets for the central bank Governors of the G10 countries, established a working group to explore the structured finance instruments used  for risk transformation  

 

In the article, BIS states that the keys to understanding the risk in structured finance products is to evaluate the risk associated with their contractual structure and to model the credit risk of the underlying asset pools. Structured finance products could be more effective than other financial instruments in addressing problems of adverse selection and segmentation in financial markets, thus attracting a variety of market participants, the report said.

 

However,  the complexity of these instruments may lead to situations where investors rely more heavily on ratings compared to other types of rated securities. The BIS noted that  ratings based on the security's first loss distribution have intrinsic limitations in evaluating the risk of tranched securities. On this basis, the risk transformation involved in structured finance gives rise to a number of questions with important implications, such as whether tranched instruments might result in unanticipated concentrations of risk in institutions' portfolios, the report said.

 

"It is argued that structured finance ratings, though useful, have intrinsic limitations in fully gauging the risk of these products, even as their complexity creates incentives to rely more heavily on ratings than for other rated securities," states the report. "Market participants and public authorities need to take account of this in their assessments of structured finance instruments and their markets."

 

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