Our Ref :  B9/24C

12 June 2008

The Chief Executive
All authorized institutions

Dear Sir / Madam,

Results of the 2007 Survey on Credit Derivative and Securitization Activities

The HKMA has recently completed its annual survey on credit derivative and securitization activities in the banking sector, covering the positions of all licensed banks and restricted licence banks at the end of October 2007.  A summary of the survey results is attached (see Annex).

The 2007 survey revealed that the overall level of activities in the credit risk transfer markets in Hong Kong continued to grow significantly, with the total gross notional amounts outstanding of credit derivative contracts and securitization exposures reported by all surveyed authorized institutions (AIs) increasing by 61% and 103% respectively.  As in previous years, the markets were heavily dominated by a few AIs, whose activities also explained most of these increases.

Many surveyed AIs, including a number of local banks, expressed an interest in commencing or further expanding their credit derivative and securitization operations.  While the use of these types of transaction could in certain circumstances enhance yield and facilitate management and diversification of risk, some of them may involve complex structures and unique risk characteristics that can be difficult to identify, measure, manage and control.   Indeed, the recent sub-prime turmoil has revealed that securitization activities can present market participants with significant risk management challenges, especially in an environment of declining market liquidity, asset prices and risk appetite.  Therefore, AIs involved in, or wishing to pursue, credit derivative and securitization business should be mindful of basic risk management principles such as those set out in the following paragraph.

To ensure that they are adequately equipped to manage potential risks associated with activities in the credit transfer markets, particularly in relation to those involving products that are structurally complex, AIs are expected to:

• carefully consider all related risks and rewards if they have a plan to commence credit derivative and/or securitization operations, and discuss such plan with the HKMA;
   

• have the ability and expertise to understand, assess and manage the risks associated with credit derivative or securitization activities, particularly in the light of the limitations of external credit ratings on structured credit products and the possible illiquidity of such products as exemplified by the sub-prime experience;
   

• establish sound risk management policies and procedures for their credit derivative or securitization activities;
   

• be aware of the potential legal and/or reputation risks arising from such transactions;
   

• maintain adequate risk management systems that are commensurate with the nature (such as complexity, volume and size) of their credit derivative or securitization portfolios and the risks involved; and
   

• ensure that their transactions exposures and positions are properly reported in the banking returns, particularly for capital adequacy and large exposure purposes.

In determining the capital treatment for credit derivative and securitization transactions, locally incorporated AIs should refer to the relevant requirements set out in the Banking (Capital) Rules.  In particular, AIs should consider the criteria for recognizing the credit risk-mitigating effects of these transactions or determining whether any structured products may fall within the securitization framework.  Where necessary, AIs should discuss with the HKMA the appropriate treatment for any new or complex structures or products that they may wish to participate in. 

In the light of the sub-prime turmoil, the Basel Committee on Banking Supervision has undertaken a series of remedial initiatives, including proposals to enhance the capital adequacy framework and risk management practices for complex structured products.   The HKMA will closely monitor the development of these Basel initiatives and consider incorporating appropriate changes to Hong Kong's capital adequacy framework and updating existing supervisory guidelines, where necessary.  Meanwhile, the HKMA will also consider whether its data collection system could be further enhanced to better capture AIs' exposures to complex-structured products given the rapid market developments and the potential risks these could entail.

Yours faithfully,

Karen Kemp
Executive Director (Banking Policy)