Securitization is often cited as one of the factors behind the current fi nancial crisis. The importance of securitization transactions for fi nancial institutions is closely related to how broadly banks should expand the range of counter- parties for trading risks in the market. The basic function of securitization is to convert bilateral trading of risks in the form of lending to trading with parties that are not directly involved in the risk origination process. In this process, the associated risks are converted to various different types of risks that are easily assumed by other market participants.
One complicated issue in this process is that this risk conversion process may often be too complicated to be understood by outside third parties, so the risk sellers could have an incentive to cheat buyers (or have loose disci- pline to comply with the conditions). Besides, if the risks are widely traded in the market, the prices formed in the market would become the basis for valuation of these risks. Even if these prices widely deviate from the prices used in the bilateral trades, they become the basis of accounting, and might sometimes entail bankruptcy of the entities that hold the assets.
Regarding this information asymmetry, a similar problem can also be found in manufacturing industry. A big difference between the manufactur- ing and fi nancial industries, however, is that consumers tend to fi nd out much earlier about the defects of products in the case of manufacturing than the case of fi nance. This is because the products (or services) dealt with by the fi nancial industry usually have a longer lifespan, which means it requires longer to reveal their defects. This feature of the fi nancial industry actually caused the fi nancial bubble and the credit cycle of the macroeconomy.
Indeed, the current crisis poses the question what is the right degree of loan securitization to balance its merits and demerits, which were signifi - cantly changed as a result of the crisis. We are now required to consider the measures to be taken to change again the right degree of securitization in its favor. This is currently quite hard to estimate in an environment in which the re securitization market has simply evaporated and trade volume, even in the ordinary securitization market, is very thin. However, we have already seen, for example, that rating agencies have clarifi ed the basis for ratings, increasing their quality. Also, a trend of increasing disclosure information on securitization transactions was gradually established. So the environ- ment surrounding securitization transactions has now started to move in the right direction, although it will take a long time for market participants to regain confi dence.
Are there any other measures that can push securitization further in this direction? For example, can any measures expand the scope of securitization
in fi nancial transactions, that is, expand the tradability of risk, improving the effi ciency of the macroeconomy? An answer could be the establishment of a market infrastructure that increases information quality, thereby expanding risk tradability. More specifi cally, the following three measures can be taken for this purpose: 1) the establishment of a framework to motivate third par- ties (mainly rating agencies) to increase the quality of their risk assessment continually; 2) clarifi cation of the defi nition of fair value in the account- ing system and the expansion of the level 3 (model price) concept; and 3) increased disclosure of risk information.
Concerning the fi rst measure, the issue is how we should establish such an incentive mechanism to motivate the rating agencies to provide accurate ratings. For example, we might be able to make an index that evaluates the medium - term relative performance of rating agencies, which could infl uence fee levels for the rating agencies. Also, as in the case of SWIFT, a global settlement organization, over which several countries ’ authorities conduct joint supervision, it may be possible for several concerned major regulatory authorities to supervise the globally infl uential rating agencies jointly in some specifi ed areas. In particular, because the risk weight of securitization trans- actions depends heavily on the judgments of external rating agencies in Basel II, the authorities may have a good reason to justify supervision of them.
The second issue is currently being discussed, but the expansion of the area in which fair value accounting is applied looks to be an inevitable trend from the viewpoint of objectivity of fi nancial conditions of fi rms, and also of accounting rule - setting bodies that put emphasis on information values for major stakeholders. This trend itself may be moving in the right direction despite events in the current fi nancial crisis. In other words, while there is a tendency in the market to overreact to events from a macroeconomic point of view (a con for fair value accounting), there could also be fraud from a micro - transaction point of view if price setting is left to a few concerned par- ties (a pro for fair value accounting). There is no need to sacrifi ce the micro perspective for the macro perspective. The bottom line is that the so - called frequently observed “ violence ” of the market can be seen as a side - effect of accounting measures to ensure impartiality or fairness of trades under ordinary conditions. This indicates that we should now think of measures to “ contain ” this side - effect.
There are some overlapping areas between containing violent market movements and maintaining the fairness of market transactions, where we do not have to worry about a possible trade - off between macro and micro issues. This is the issue involved in defi ning the concept of the level 1, 2, and 3 hierarchy of fair value, which is used in the US. This issue relates to the question of how we should recognize the timing when transforma- tion of market information from the highest common factor of all market
150 POST-CRISIS RISK MANAGEMENT participants moves to a biased one by a few market participants with extreme positions (or how whether we can really recognize this timing).
Another question is how we should revise the biased information based on the answer to the fi rst question.
These questions actually reveal a fundamental problem of the current accounting system. This is its principle of not considering “ forward - looking ” information in the judgment of the appropriateness of price. The market nat- urally forms prices considering the impact of business cycle factors on prices in a forward - looking way. Under the current accounting system, however, it is diffi cult to keep continuity of prices if normal prices suddenly evaporate in the market. Indeed, it seems to be inevitable to consider forward - looking ele- ments in price formation explicitly, even in the world of accounting.
We have already discussed the third and fi nal issue in chapter 4 . The important point is the increase in disclosed information to match the demand of market.
On this issue, for example, it may be an interesting idea to establish a system that clarifi es the traceability of risk, as recommended by the report made by a fi nancial market strategy team set up by the fi nancial services minister of the Japanese government in 2007. This could surely increase the trading costs, which then could be reduced by innovations. Establishment of risk traceability can be interpreted as the increase in transparency of risk assessment at each step of securitization. For example, if we can label all the derivative transactions made in the market with a standardized code number that is accompanied with the basic risk profi le information, and can access easily all this information on the internet, risk traceability could be signifi cantly improved.
Also, in this case, we do not have to wait for the reactions of the accounting rule-setting bodies regarding derecognition criteria as the regu- latory authorities could easily request all fi nancial institutions to perform a strict “look-through” for all transactions under the Basel II Accord based on the traceable data. It becomes clear that, if fi nancial institutions adopt Basel II and are required to look through their assets backing up their securitized papers as a regulatory restriction for them, the off-balance standards would not yield any signifi cant problem, regardless of their accounting standards.
Based on this lesson, all the regulatory authorities should request all fi nan- cial institutions to strictly look through their off-balance standards.
Meanwhile, it is necessary to declare that this type of disclosure would not be required for one-off bilateral transactions between fi nancial business professionals (while the authorities should not allow these transactions to be securitized in the market). This is because these transactions would not be assumed to be tradable. Therefore, accounting value should also be based on fundamental value calculated by the models. The idea is that we should
request fi nancial institutions to recognize model and accounting risk associ- ated with liquidity risk in return for the merits of tradability or the increase in liquidity owing to securitization. Conversely, we should not request them to recognize these risks for the transactions that do not enjoy merits of liquidity.
To improve the reliability of the risk profi le information discussed, the authorities might be required to check some samples periodically. Also, to facilitate the authorities’ conduct of a credit-cycle-smoothing macropruden- tial policy, it is important to establish a system that enables the authorities to analyze risk scenarios based on information with various angles such as product features, originators, arrangers, geographies, and rating agencies.
At any rate, it is next to impossible that we will see the renaissance of the near-dead securitization market in the near future if we cannot establish a new market infrastructure with the joint efforts of market participants and the authorities, as shown.