GC’s Krohn: New wave of credit risk rules set to reshape financial markets

Guy Carpenter’s managing director and mortgage and structured credit segment leader Jeff Krohn revealed how post-financial crisis regulatory reforms are pushing US banks towards new credit risk transfer regulations, with lower-cost capital solutions and investor scrutiny driving financial stability.

He noted that changes first applied to government-sponsored enterprises such as Fannie Mae and Freddie Mac were subsequently imported to European banks.

This impact is still being felt today as US banks and financial institutions are facing a raft of newly-approved or draft regulations, he said.

Aside from regulatory changes, Krohn added that the financial crisis has taught lessons to all entities.

“One of the things that we've learned is that regulators and financial institutions should have access to multiple sources of capital, in both investor-backed and reinsurer-backed credit risk transfer.”

Why use risk credit transfer?

According to Krohn, financial regulators favour credit risk transfers because it prompts the financial institutions that they are overseeing to have third parties ask questions about and verify their portfolios and underwriting practices.

“Financial regulators and financial institutions alike love having access to sources of external capital. The more sources, the better. Reinsurance represents one of those sources; investors, the others,” he said.

Krohn highlighted that from a capital management perspective, credit risk transfers provide financial institutions with lower-cost options to protect against risk.

He noted that these financial institutions must hold regulatory capital at very remote risk levels. They could hold the equity capital against the remote risk, this would come at a cost of between 12 and 15 percent.

Krohn questioned why institutions would do that when the reinsurance market can offer that capital at a lower cost of approximately 2 to 4 percent.

Initially, regulation was designed to transfer risk away from the US taxpayer. However, as the regulations and capital requirements have evolved, there is now a push to release them from conservatorship. This would help support and enhance the capital build process, he said.

Key considerations when establishing regulatory capital requirements

“Firstly, there has to be a risk-based capital framework, because not all risk is the same. For example, a mortgage loan isn’t the same as a corporate loan,” Krohn said.

In addition, the other part of the framework will consider the distribution of outcomes for each of the asset classes, including expected loss or mean and unexpected losses. He emphasised that it is the unexpected losses that primarily drive the capital requirements.

Watch the 10-minute interview with GC’s Jeff Krohn to hear more about: