Despite the aforementioned benefits associated with banks engaging themselves in loan sccuritisation, securitisation activities warrant the application of prudent conduct and due diligence. Otherwise, they could increase the overall risk profile of the issuer. Even though the securitisation of loans involves the same degree of risk exposures as bank lending business, which stems from credit risk, interest rate risk (including risk from prepayment), concentration risk, operational risk and liquidity risk, the Basle Committee confirms the notion that unbundling the traditional lending function into several limited roles is prone to inflict more complex credit risk on issuers of CLOs. With the credit risk being shared between several stakeholders in the securitisation process, i.e. originator, servicer, sponsor, credit enhancer, liquidity provider, underwriter trustee, investors and, as need be, credit derivative counterparty, an additional layer of administrative and processual complexity confounds the aforementioned types of risk, whose impact on the risk sensitivity of the reference portfolio might be markedly different from traditional lending. This observation especially applies to interest risk, since securitised loans are commonly regarded more sensitive to interest rate movements than unsecuritised loans, as they display a higher positive correlation between the probability of rating change to interest change. However, by way of explaining the different nature of risk in structured finance transactions, the consequences for the assessment of investors' claims on the reference portfolio of a CLO are straightforward. Whereas the quality of the reference portfolio (credit rating) is determined by the assumptions entering the credit risk assessment and management system of the issuer, structured ratings have to take into account the complex nature of CLOs and the diverse risk patterns imposed by the various agents in the securitisation process.
Credit Risk--An Issue Of Diversifiability
We first need to shed light on what actually constitutes credit risk and how the properties of credit risk warrant particular methods of mitigating its adverse effects on the bank loan book. From a management perspective, Oldfield and Santomero (1997) argue that uncertainties, i.e. risk associated with the completion of conditional counterparty promises, facing all financial institutions can be segmented into three separable types. These are:
* risks that can be eliminated or avoided by simple business practices,
* risks that can be transferred to other participants, and
* risks that must be actively managed at the firm level.
Credit risk arises from non-performance by a borrower, which is caused by either an inability or an unwillingness to perform in the pro-committed contracted manner. If two parties engage in a loan contract, i.e. a contractual obligation such that funds are transferred from one party to the other for an agreed period of time in return for compensation in the form of interest, the probability of commitments to be honoured gives rise to such inherent uncertainty.
This uncertainty can affect the lender holding the loan contract, as well as other lenders to the creditor. The risk inherent in the intertemporal compensation for the periodic transfer of wealth between the provider and the recipient of capital in external finance warrants an accurate prediction as to its default probability and loss severity. Such as measurement is irrespective of the means of external finance, be it corporate bonds, bank loans or any other form of debt securities or credit obligations, such as underfunded pension provisions. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. In order to prevent the assessment of financial strength as a proxy of the probability of repayment at the agreed terms and conditions set out in the loan contract from being of conjectural nature, banks employ clearly defined credit rating systems in order to quantify the capacity of lenders in generating sufficient future cash flows to meet scheduled repayments required by the lender. Credit ratings address the likelihood of full and timely payment of principal and interest to lenders and expenses of other third parties involved.
Given a portfolio of loans, the real risk from credit lenders face is the deviation of portfolio performance from its expected value. Accordingly, once standardised and made comparable, credit risk is diversifiable, but difficult to eliminate completely, as market risk and interest rate risk as systematic impediments defy diversification to the effect the financial strength of debtors and the funding sensitivity of the creditor respectively. With respect to the transferability of credits, loans cannot be distinguished along the lines of diversifiability of risk on the basis of an exclusive distinction of either interest rate risk exposure...