Recent policy issues regarding credit risk transfer

Over the last decade, a variety of financial tools have been developed for transferring credit risk between financial institutions. Credit risk is defined as the risk that the value of a corporate loan (or debt obligation more generally) will decline due to a change in the borrower's ability to make payments, whether that change is an actual default or a change in the probability of default. Credit risk transfer (CRT) mechanisms range from outright selling of loans to credit derivatives that permit shifting credit risk without necessarily referencing specific loans. ; As new varieties of CRT mechanisms have developed, so has the volume of CRT transactions, and this has increased liquidity in the underlying bond and loan markets. In conjunction with this growth, the policy issues surrounding CRT transactions have changed in important ways. For example, if a seller of a credit derivative fails to fulfill its contractual obligations, the purchaser of credit risk protection could unexpectedly find itself exposed again to that risk. In addition, regulatory concerns regarding CRT arise from the potential damage that might be caused by credit risk concentrations within the financial system. This Economic Letter provides a brief description of the common types of CRT mechanisms and reviews the policy issues surrounding their use, especially with respect to credit derivatives.