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Structured finance : complexity, risk and the use of ratings

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Financial Stability Review 2005 127 STRUCTURED FINANCE : COMPLEXITY, RISK AND THE USE OF RATINGS Structured finance : complexity, risk and the use of ratings (1) Ingo Fender (BIS) Janet Mitchell (National Bank of Belgium) Introduction Structured fi nance involves the pooling of assets and the subsequent sale to investors of tranched claims on the cash fl ows backed by these pools. It has become an increasingly important tool for credit risk transfer. Issuance volumes have grown rapidly over recent years (Chart 1), paralleling technical advances in credit risk modelling. Like other forms of credit risk transfer − e.g. credit default swaps (CDSs) or pass-through securitisations − structured fi nance instruments can be used to shift credit risk across fi nancial institutions and sectors. Yet, a key difference between structured fi nance and other risk transfer products is that, via the tranching of claims, structured instruments also transform risk by generating exposures to different “slices” of the underlying asset pool’s loss dis- tribution. As a result of this “slicing” and the contractual structures needed to achieve it, tranche risk-return char- acteristics may be particularly diffi cult to assess. Ratings, which are based on the fi rst moment of a security’s loss distribution, have intrinsic limitations in fully gauging the risk of tranched securities. While this observation holds in principle for any security, it will be argued below that the tails of these loss distributions are likely to be more pro- nounced for structured products (2). As a result, subordinated structured fi nance tranches in particular can be expected to be riskier than portfolios of like-rated bonds in that inves- tors in the former are more heavily exposed to extreme loss events. Yet, the complexity of structured fi nance transactions may lead to situations where investors tend to rely more heavily on ratings than for other types of rated securities. On this basis, the t

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