Identifying the Information Polarities in Credit Risk Transfer Instruments; A Case for Regulatory Product Intervention and Product Liability Framework

Abstract

Financial innovation provides an accommodating avenue for parties to develop strategic means to prevent or avoid risk by spreading it across the financial system through efficient transferral to other parties. This transferral is done in numerous ways, the most notorious of which is through Credit Risk Transfer (CRT) Instruments. Consequently, the ideology of moving risk or seeing risk as being valuable and the ease of doing such transferral feeds the risk appetite of investors and makes them underestimate the implication of the credit risk they take, making investors fail to take the required protective measures to prevent excessive risk acquisition. The Credit Risk Transfer Markets allow the efficient flow of capital allocation and highly liquid Credit Risk Transfer instruments. By enabling this, markets consequently permit opportunism in risk management by propelling the ‘originate-to-distribute’ model of the Loan and Credit markets. The opportunism process goes thus: human error and moral hazard are encouraged by under collateralisation and risk dispersal mechanisms that tangle-up various Credit Risk that is easy to market in a period of increased risk appetite. Needless to say, the process is not always so straight-jacketed. Liberal regulatory and supervisory responses strengthen the opportunism by allowing the polarisation of Information accumulation. The information being the basis on which investor decisions are made require comprehensive and ‘faithful’ disclosure which, unfortunately, usually is not the case in Credit Risk Transfer. An accepted but irrational belief in the notion that excessive information about the constituent credit risk formulating a substantial portion in a pool of credit instruments or a genre of derivative financial products deters liquidity and investor interest; is a creed in the primary financial institutions. Regulatory intervention is further hindered by the belief in the market mechanisms ability to ‘correct anomalies’ more efficiently than a direct and precise regulatory intervention would. The aim of this work is to attempt pointing out the flaws in the liberal regulatory attitude to Credit Risk Transfer activities and advocate a more welfare-suitable approach to Credit Risk Transfer regime by focusing on information availability and collection, and by examining regulatory systems that have been time-tested on their welfare suitability and information efficiency. Though theoretical in nature, this work seeks to serve as a medium for inter-doctrinal analysis of financial products by developing on the legal theory of finance